24 x 7

Barack Obama Starts off in Chicago

2008-11-10T21:19:00.000-08:00

China meets his match -- Reliance de-merger demystified.

2008-08-25T04:49:00.001-07:00

Wafers had a cup of Cappuccino in one hand and a piece of roasted papad in the other. “Terrible combination” thought the captain, but decided to keep his counsel. As the clock chimed six, China walked in. “Hey, Wafers, tell me what is price-discovery”? He said that without even so much as a “Good evening.” Wafers bit the bait. It was her one opportunity to carry coal to New Castle. “Look, price discovery is the process by which you find the fair price of a stock through the interaction of buyers and sellers dealing in the stock market.” Sipping cappuccino, Wafers remarked, “But China why do you ask”?

“I read that the NSE and the BSE held a special one-hour session on 18th January 2006 exclusively for the trading of the Reliance stock to enable ‘price discovery’. That got me curious” explained China. “Don’t the stock exchanges make a living out of continuously discovering prices? Why did they need a special session?” It was Wafers’s second opportunity to carry coal to New Castle.

Mopping her hair up she said, “You see, Reliance Industries Ltd (RIL) is de-merging leading to four new companies apart from Reliance. Now, RIL has the highest weight on the Sensex and the second highest weight on the Nifty. Upon de-merger some of the assets of the company will be given to the four resulting companies which would mean that for the investor the value of the Reliance stock would come down. And, while RIL will continue to be on the Index the resulting companies will not form part of the Index. That would mean that the Index too would fall. Hence the opening level of the indices for 18th Jan had to be determined”, demystified Wafers.

“Well, that explains it,” remarked China. And wondered, “But I can’t understand one thing. The dispute was between bade miyan and chote miyan. So, why is the de-merger yielding 5 companies?” Ha, here was another opportunity for Wafers to play Ms. Know All. She explained, “True. Apart from RIL there are four other, what we technically call, ‘resulting companies’ namely Reliance Communication Ventures Ltd, Reliance Energy Ventures Ltd, Reliance Capital Ventures Ltd and Reliance Natural Resources Ltd. Now, RIL was not only an integrated petrochemical business but was also well diversified. It had exposure to Power business, Finance and Investment, Natural Resources and Telecom. The de-merger was an opportunity to restructure the group into companies handling vertical businesses.”

“Oh! I see,” remarked China.

“Well, to make matters even more intriguing, two of the resulting companies will soon merge with the companies that they hold”, added Wafers. “Reliance Energy Ventures Limited and Reliance Capital Ventures Limited will be merged with Reliance Energy Limited and Reliance Capital Limited respectively which are actually the principal shareholders in the amalgamating company!” China nodded. Wafers was sure that if she told him about holding companies and special purpose vehicles he would see stars.
“Now what are the tax implications?" asked China. He had over time invested in 1,000 shares of RIL at an average cost of Rs 550 and was wondering whether the de-merger would lead to taxes at his hands. Wafers ordered two more burgers. She was beaming. For, It wasn’t every other day that she had the opportunity of educating China. “For every share in RIL you get one share each in each of the four companies”. China thought, “So four thousand new shares for me on the whole.” And asked, “Do I pay capital gains tax now.” Wafers explained, “Nope. At this point there is no capital gains because the issuing of shares under a de-merger is not a transfer” Someone hissed “Section 47?” Wafers turned around stunned but could see no one.

“Of-course there would be capital gains when the shares of RIL or the resulting companies are sold?” asked China. “Yup” said Wafers. And added, “at that point the date of acquisition will become important in deciding whether the gains are long term or short term. That date will be the date on which you acquired RIL”. Wafers heard someone hiss Sec 2 (42A). She turned around but found no one.

“So if I had bought RIL six months ago and sold Reliance Capital Ventures seven months later, the total holding period of Reliance Capital Ventures will be construed as 13?” asked China. Wafers wasn’t surprised that her friend was quick on the uptake. “Yes” she said. And added, “In that case the gain will be long term capital gains and will be tax free. If the total holding period is less than 12 months it would count as short term capital gains and will attract 10% tax. “Section 111 A.” “Was she hearing voices?” wondered Wafers.

“Okay!” exclaimed China. “In that case the cost of acquisition becomes important. And how do I compute it?” he asked. Wafers was ready with her answer. She reeled out the Section that she had crammed into her head. Section 49 (2C). “The cost of acquisition of the shares in the resulting company shall be the amount which bears to the cost of acquisition of shares held by the assessee in the de-merged company the same proportion as the net book value of the assets transferred in a de-merger bears to the net worth of the de-merged company immediately before such de-merger” China almost spilled his cappuccino. “But from where do I pick those numbers” from he asked. “RIL has issued a guidance on 16th Jan” guided Wafers. “Lay your hands on one.”

China wasn’t through as yet. “You said two of the resulting companies would be merged with two other companies. What is the tax position in that case?” asked China. “Same as is the position with de-merger” remarked Wafers. China pointed out, “The scheme of de-merger and the subsequent amalgamation plans are tax-efficient.” Wafers couldn’t help but caution, “Whether they turn out to be strategically sound for the legacy of Dhirubhai remains to be seen.”

“I am impressed,” said China. “With Reliance’s planning or my erudition?” asked Wafers. And on a sudden idea, she added, “How come you did not know any of this?” China smiled. “Of course I knew it all. I was just checking if you knew it! See, you have to crack May 06.” Wafers almost threw the cappuccino on China’s face.

Volcker Report

2008-08-25T04:48:00.001-07:00

When the Volcker report hit headlines in October 2005, Wafers’ heart skipped a beat. 20 years ago, in April 1986, her dad had gone through similar pangs when the Bofors story broke out. She wasn’t too sure whether she understood Volcker just as her dad had understood precious little of Bofors. So, she decided to chat up with her friend China.
Wafers did some quick homework. She learnt that in 1990, following the Gulf War, the United Nations (UN) had imposed economic sanctions on Iraq. This had hurt the civilian population. The law of “unintended consequences” of which her professor had once explained had been at work! To mitigate the hardship, in 1995, the UN conceived the “Oil for Food Program” (OFFP). Under this program the UN allowed Iraq to sell its oil and use the revenues to buy relief supplies. The sale was to be at a UN decided “fair market price” and the proceeds were to be deposited to a UN-controlled escrow account from out of which relief supplies were to be bought. At no time did Saddam Hussein have access to these funds. In November 2003 the program was phased out.
China made a quite entry to the cafe. Sipping into her coffee, Wafers asked, “Did this scandal blow up on our face overnight?” The walking encyclopedia responded. “No. It is a two years old story. In early 2004, an Iraqi newspaper named UN officials, politicians and companies who may have profited from the illegal sale of Iraqi oil during the OFFP. It alleged that Saddam Hussein had embezzled millions of dollars through under-priced oil sales and over-priced purchases.” To Wafers, it rang a bell. Her auditing guru had talked about how one should scout for over-billing and under-invoicing while conducting management audits. Ha, a practical application indeed.
“Now if I have understood this right” said Wafers, “The Volcker committee was constituted by the UN itself and Paul A Volcker had impeccable credentials”. The captain at the table, overhearing the conversation said, “That’s right.” Wafers asked, “What were the principal findings?”
“Kofi Annan, Cotecna and Kojo Annan” remarked China. And then explained. “The UN Secretary General, Kofi Annan’s son, Kojo Annan, is a former employee of Cotecna, one of the companies that contracted with the OFFP. Cotecna’s contract with the UN, signed on December 31, 1998, enlisted the company in the authentication of imported humanitarian goods as part of the OFFP. Kojo was employed with Cotecna till 1998 i.e. before the contract was signed but was still being paid by Cotecna as a ‘consultant’ till 2004”. Wafers was aghast. “Don’t tell me that a contract cannot be awarded to a professional company because an employee happens to be dad’s son!” The captain smiled and said, “That’s the price you pay for being the son of an illustrious father.” China snorted, “Caesar’s wife should be above suspicion”.
Wafers wondered, “Did Volcker nail Kofi?” Reading her mind, China responded, “The Volcker committee investigated the possibility that Kojo Annan used his UN contacts to secure the award of the contract for Cotecna. But it did not find any evidence”.
“I guess the main plot is how Saddam Hussein, the butcher of Baghdad, had manipulated the OFFP” said Wafers. “Volcker reported that about 2,200 companies including 129 Indian companies had paid kickbacks to Saddam Hussein’s government, right?” she asked. “Yup” said China, a shade surprised that Wafers was also aware of life outside chartered accountancy! “But how did it work?” Wafers wondered aloud. It was her signal to others that they had better brief her.
A smiling China responded, “The Iraqi government handed over oil sale contracts to individuals, organizations and political parties considered to be ‘friends’ of Iraq; in particular, to permanent members of the Security Council who were in a position to ease sanctions”. The captain chipped in. “The oil allotments were made at UN approved prices to nominees of these political beneficiaries. Iraq negotiated with the nominees and asked them to pay a surcharge into bank accounts that were in the name of Iraq’s State Oil Marketing Organisation. The nominees then made their profits by selling the oil at market prices to oil companies. A part of the profits went to the beneficiary”.
China added, “In the case of imports, ‘after-sales service provisions’ and ‘inland transportation fees’ were incorporated in the invoices to inflate prices. This helped contractors to recover from the UN escrow account, amounts that they had paid to Iraq as kickbacks. The balance was pocketed by Saddam”. Wafers was beginning to get a sniff of the scandal.

“What about the Indian connection?” she asked. China explained, “Mr. Natwar Singh, the former foreign minister, the Congress party, Mr. Bhim Singh of the Panthers party and Reliance Petroleum have been named as non-contractual beneficiaries. Masefield AG, a Switzerland-based oil trading company, lifted the allocations made to the Congress and Natwar Singh. The intermediary nominee in this case allegedly was Andy Sehgal and his company Hamdan Exports”. Wafers interrupted; “but Andy has gone on record saying that he hasn’t “touched a barrel of oil in his life.” China winked, “Viola, you don’t have to touch a barrel to deal in one!” The captain said, “Bhim Singh did not lift the oil while the allotments to Reliance were lifted by Alcon Petroleum Ltd”. And then added, “The non-contractual beneficiaries have been so called because they have not actually traded in oil on their own.”

Wafers was ready to offer a judgment. She now felt that she had cracked the Volcker puzzle. Her judgment came courtesy a series of questions. “Why are we barking up the Congress and the politicians? Why have we spared the companies that were named? What is this nonsense about pocketing the difference between actual market price and fair market price? How can the fair market price be fair if it is below the actual market price? Is this not a commercial transaction where two parties have the right to decide on the terms of sale?”

“Finally, these allegations are based on the documents of the Iraq government that fell into the US hands after the Iraq invasion. There has been no corroborative evidence. A mere name in a document cannot be proof of wrong- doing. If that were so, then leading politicians named in the Jain diary (famous Jain hawala case) should be behind bars.
China smiled. “Wafers, there are some things that may look legally right but which are morally wrong.” The captain said, “It is time to pull down the shutters”. Wafers wondered, “On the Volcker scandal or the coffee shop”, as she walked out with China into the long night.

Where is the Law?

2008-08-25T04:46:00.000-07:00

“Did you know that the Supreme Court of India works for 185 days and the High Courts work for 210 days in a year?” asked China. Wafers did some quick arithmetic and said, “That means India’s apex court is on a holiday 50% of the time and the high courts take off 40% of the days in a year”. China smiled. He looked smart, thought Wafers. “Hey, tone down. You could be hauled up for contempt of court” said Rinku stuffing in another bite of pasta. It was all that China could do to keep his cool.

“My foot,” he bawled. The gang was stumped. The yuppie engineer-to-be from IIT had studied at one of India’s top residential schools and was known to be sober. Clearly something must have upset him. Said China, “Look I peeped into the Internet and found that as of March 2004 there were 22,000 cases before the Supreme Court, 33 lakh cases before the High courts (of which 41% were overdue by five years) and 228 lakh cases were hanging fire in subordinate courts (of which 30% were pending for more than five years).” Wafers recalled her senior who in audit was ever preoccupied preparing an ageing schedule of debtors!
Rinku (to Wafers’ anguish he was now sporting a John Abraham hairdo) sipping his coffee remarked, “According to the Guinness Book the most protracted lawsuit took place in India. A `temple keeper (a k a Mahant) filed a suit in Pune in 1205 A.D., and the case was decided a full 766 years later, in 1966!” As Wafers laughed, Rinku chided, “This is not the average time taken by the Indian courts for deciding cases. Normally a case takes between seven to fifteen years to be decided”. Wafers remembered the Bofors story that had broken out in 1986 tarnishing the fair image of Rajiv Gandhi. Nothing had come of it even after 20 long years.
“How are things elsewhere in the world?” she asked. The captain brought in potato chips that China loved. Munching one China said “Let me give you an example from the capital market”. Wafers sat up. The Sensex had crossed 8400 and she was interested. China was saying, “Back in 1995, the derivative trader Nick Leesson brought the 150 years old Barings bank to its knees through his reckless trade in the derivatives market. Today he has not only completed serving his prison term; last heard of he had written a book on the subject which was made into a movie”. Wafers could not miss the irony. In India the cases relating to the 1992 scam were still on. It was another matter that the principal protogonist Harshad Mehta was no more!
Rinku, although appreciative of contempt of court, decided to recount a first hand experience. A few months back he had to frequently visit a lower court in connection with a criminal case in which a close friend was falsely implicated. “In most of the hearings, the main agenda is to fix the date of the next hearing. If at all they serve any purpose, it is to identify the hidden athletic talent in the country!” Wafers sat up interested. “As soon as one’s name is called out by the court clerk, in the most disrespectful way imaginable, one has to push through the milling crowds which block the entrance and make a fifty meters dash to stand in front of the judge. Any delay would result in a severe reprimand! And having folded his hands in front of the magistrate, one is told when to come for the next hearing”!

China smiled popping another potato chip into his mouth. And said, “When trials take place, one can make out very little of what is going on. Lawyers speak in hushed tones. The magistrate’s voice cannot be heard. Worse still when there is so much backlog pending in the courts, our courts do not even put in a decent eight hours of work a day. Cases keep dragging forever. But the lawyers do not seem unhappy”.

Wafers asked, “Why is this so?” China responded. “Perhaps it has, in part, to do with the way the fee is structured in India. Unlike in the US where lawyers work on an incentive based system, here, they collect fees per document generated or per court hearing”. Wafers thought, “Oh piece rate workers.” Rinku remarked, “So the more the number of hearings, the more the fees they can collect”. Wafers murmured, “For the client, a variable cost”. China closed out, “Did you know that the lawyers in Tamil Nadu went on strike during the summer of 2002 to protest against government moves to dispose of cases speedily?”

Wafers agreed that the lawyers were a privileged lot. After all they were the only professionals who didn’t have to pay service tax. Or may be like the lawyer turned politician, P Chidambaram had once wisely remarked, “they are not required to pay service tax because they do not render any service.”

China turned to Wafers and asked “What would you suggest?” Wafers didn’t think for long. “Judges must be paid handsomely. There must be incentives for judges to finish cases. We don’t want kangaroo courts but cases must be expeditiously dispensed with. The courts must work in two shifts”. Rinku who had done some research on the subject said, “A national Commission has recommended that there should be 50 judges for every 10 lakh citizens. But we have only 10 judges for every 10 lakh citizens.” Wafers nodded. Her professor had once said, “In modern society, speedy and efficient legal processes are very important. Without a sound legal system, it would be difficult to safeguard property rights, impossible for businesses to function, tough for the innocent to defend themselves and difficult for the guilty to be taken to task. Unfortunately, our outmoded legal system is a major stumbling block in the reform process. The guilty can prolong cases taking advantage of loopholes in the system”.

China said, “Despite its lacunae the legal system has stood up in India. But the law must not only work. It should also be seen to be working. You cannot progress as a nation unless the populace has the fear of law in its mind.”

Yeh, bonus ka mamla hai

2008-08-25T04:44:00.000-07:00

“Hey, that’s sexy” cooed Wafers. China was reminded of his “ragging” days at IIT. A senior had asked him to define sexy. China had blanched. And was promptly pulled up for having a dirty mind. Someone explained, “It is ‘1/Cos C’ my dear.” China almost puked.

“Look WIPRO has announced a 1:1 bonus” said Wafers. “So what’s sexy about it?” asked China. “You see, for every one share held I get one free. I have 50 shares; I will now have 100” she said. That statement took Rinku’s breath away. He worked for a pink paper and was shocked that someone doing her CA final could lay such an egg.

“Hey, the 50 shares aren’t free money” he said. “I know” cracked Wafers. How could she forget. Her professor had once famously explained why bonus does not increase wealth. He had said, “A bonus cannot create wealth. All that happens is that reserves are transferred to equity account. If wealth can be created by an accounting entry then companies do not have to produce goods and sell them. They just have to engage accountants to keep capitalizing Reserves!”

“Okay, tell us what is it that you know?” Rinku asked Wafers. Wafers was hurt, but she didn’t show it. “A bonus issue doesn’t change the wealth of the firm. With the numerator (market capitalization) remaining unchanged and the denominator (number of shares) going up, the price per share will fall. Theoretically a 1:1 bonus would bring share price down by half”. China chimed, “You mean what you gain on the old share you lose on the new.” Bravo.

“That being so why would anyone be excited by a bonus” wondered China. Wafers was thrilled at the prospects of carrying coal to Newcastle. “See, there are many reasons. Like, the share price falls and brings it within the comfort zone of the investor”. Rinku chipped in. “She means that an investor is happier buying two shares at 360 each than one share at 720. Right?”

Wafers’ professor had called the phenomena mental accounting. He had narrated a story. “Jeanne had gone to a casino in Katmandu and had staked Rs 100/-. She won Rs 200. She then staked the Rs 200 as well and saw it double. She kept winning until she had won Rs 5,00,000. Then the tide turned and in one shot she lost it all.” The professor had asked, “How much did Jeanne lose?” The class roared “Rs 100”. The professor had sworn that they would make great accountants. “The accountant thinks he has lost Rs 100 because that’s the money he would debit the gambling account!”

Somebody had hissed, “The economist would know that Jeanne had lost Rs 500,000”. While agreeing with it, the professor had tongue firmly in cheek remarked, “An economist is one who when he sees a Rs 100 note on the road says that this cannot be a Rs 100 note because if it had been one someone would have picked it up.” The class had roared in approval.

China asked, “Price fall apart, what else is it about bonus that would excite an investor Wafers explained. “When the share price falls, investors move in to buy shares. They read a positive signal in the bonus. A company would not declare bonus unless they are sure of servicing it in the future. So the demand for shares goes up and the price too goes up.” China echoed, “The law of demand and supply in operation.” Right.

“Hey, that’s sexy” cooed Wafers a second time. “Look ITC has announced a 10:1 stock split in addition to a 1:2 bonus” she said. “So what’s sexy about it” asked China. “You see for every two shares that I hold I get one share free. And then these three Rs 10 shares are taken away from me and I get 30 shares of Re 1 each. So from holding 2 shares I now hold 30. It was now China’s turn to be stunned. “Now doesn’t the stock split look frighteningly similar to that of a bonus?” he asked.

“Yup”, said Wafers. “But there is a difference. In accounting speak, we don’t have to transfer money from reserves account to equity account” she purred. This time around she was glad carrying lignite to Neyveli! China remarked, “From what you said, the Rs 1800 share will start quoting around Rs 120.” [(1800X2)/30]. Wafers wasn’t surprised. China wouldn’t be China if he wasn’t that quick on the uptake. “Yeah, you are right” she said. “And for the same reasons that I explained in the case of bonus, demand will begin to build and the price will climb up.”

Rinku stepped in. “See bonus and stock split can actually work the other way too. In the case of ITC, an investor having 100 shares would as per your computations now have 1500 shares. He could step in to sell some. As pressure builds up and supply outstrips demand prices could actually fall.” China said, “So all bonuses and all splits aren’t necessarily good.” Wafers agreed. In the end it depends on what the market perceives. “Yes, the price could go up or it could come down.”

China complimented Wafers for speaking like a true analyst! He remembered an analyst who when once asked by a scribe as to which way the market was headed in the short term had said, “The market might either go up or might come down!” Bravo. The journalist had then rubbed in. “Mr. Analyst the market could also move sideways”. A distinct touché indeed. Or was it a PJ (poor joke in IIT lingo?)

“So economics apart, it is all a mind game”, said Wafers unmindful of the jibe.

Corporate Governance kya hai.

2008-08-25T04:43:00.000-07:00

Wafers sat under the moonlight looking at the stars. It was the weekend and she had had a tough week at office. She let her mind run, very unlike Wafers! She was thinking of how fashions have changed. Hey, no; she wasn’t thinking about dresses. She was thinking about jobs. Once jobs in the information technology sector were hot. Then came the craze over business process outsourcing. And now Sox. She smiled. She was reminded of Chuin’s (her kid brother) socks. He rarely washed it. Her mom was a doctor and he prided himself saying his socks would provide anesthesia to any patient.

China, her bosom pal, dropped in. She decided that she would check out with him about working on Sox, in particular in areas relating to corporate governance. She would be a CA come May 2006 and was already weighing her career options. She felt that the noise over corporate governance was misplaced. For, in her mind, corporate governance was like “quality”. You cannot show case it as a unique selling proposition (USP) since it was a bare necessity for any good corporate citizen. She wasn’t surprised that both Infosys and the Tatas were at the top of the pecking order in a recent national survey on corporate governance.

“Hey, tell me why this fuss over governance?” she asked China. “Simple”, remarked the IITian. “Corporate governance is concerned with the interface between directors, senior managers and shareholders of companies.” Wafers yawned. A legalese? Where had she read this? China ignored the jibe. “Most shareholders do not have the time or the inclination to monitor the functioning of a company. So they leave it to the board of directors. In recent times, in view of the spectacular collapse of companies like Enron, the subject of corporate governance has been receiving great attention”.

Oh how could Wafers forget Enron! Her dad had told her about how reams of newspaper columns were spent by the BJP pulling up the Congress for doing business with Enron and then when it came to power the BJP itself had inked the deal! Very funny, she thought. China, sipping his third mug of coffee (if he sips at this rate he will grey before he turns 30 thought Wafers) was saying, “Among the issues being discussed are who should be on the board, what should be the checks and balances on senior managers, what kind of incentives must be given to align the aspirations of senior managers with the objectives of the company, and the kind of disclosures which the management must make to investors from time to time. Several committees had submitted reports on measures for improvements and many of these reports have been widely publicized and intensely debated. In the US, the Sarbanes Oxley Act (Sox) has been introduced to impose greater accountability on CEOs.”

Wafers wasn’t willing to buy it. “I think in all these reports on corporate governance we are mistaking the woods for the trees” she said. And added, “Many of the US companies which ran into trouble had all the corporate governance mechanisms in place, at least on paper”. “Explain” said China. “For example, the Enron board was a model board. When Enron went kaput, it was in full compliance with the governance provisions of the much publicized Sarbanes-Oxley Act, with the exception of loans to some corporate officers. Enron also had a truly independent board. Only Ken Lay and Jeff Skilling were insiders in a board of 14 directors”. China nodded. “Many of the directors were highly qualified. Some were heads of major corporate or non-profit organizations. Others had significant governmental and regulatory experience. All the audit committee members were independent. In 2002, the Enron board was judged as one of the five best boards in the country by the Chief Executive magazine”. Wafers was flowing like a torrent and China liked that.

“Hey, I couldn’t agree with you more” he said. “Actually, according to William Niskanen, Chairman of the prestigious Cato Institute there is no evidence that a company’s performance is related to the proportion of independent directors. Over the past 20 years, many studies have tested this relationship and have reached that conclusion. Audit committees, compensation committees and codes of ethics, have been of little use in preventing corporate governance failures.”

Wafers remembered what her professor who taught CLSP had told the class. “In India several committees have been set up to improve corporate governance. But talk to people who sit on boards and they will admit that nothing much has changed. More high profile people may have been added to the board. Sitting fees might have gone up. But the real challenges remain. Most Board meetings are superficial and held to satisfy compliance requirements. In many cases, agenda papers are not circulated in advance. Far too much time is spent discussing trivia, important points are taken up for discussion towards the end of the meeting when the concentration of the board members has started to sag”.

Wafers wondered whether the rules could cover certain matters of the heart when it came to governance. China recalled what Jeffrey A Sonnenfield had written in the Harvard Business Review. “We’ll be fighting the wrong war if we simply tighten procedural rules for boards and ignore their more pressing need -– to be strong, high-functioning work groups whose members trust and challenge one another and engage directly with senior managers on critical issues.” China remarked, “The most important step is to create a climate of trust and candor. Directors must develop alternative scenarios to evaluate strategic decisions. They must be involved in the management of the company’s affairs”.

“So does this mean that Sox is hogwash” asked Wafers. “Not really” said China. “In the 20th century shareholder activists, accountants, lawyers, and analysts had highlighted the importance of independent directors, audit committees, ethical guidelines, and other structural elements that can help ensure that a board does its job. They’re necessary but not sufficient conditions for good corporate governance”. Wafers nodded. And then added, “If a board is to truly fulfill its mission to monitor performance, advise the CEO, and facilitate effective stakeholder management, it must become a robust team whose members have complete trust in each other”.

Wafers’ mobile rang. Her mom was on line. She had to return home.

He, who moves first, moves fastest.

2008-08-25T04:42:00.000-07:00

The legendary professor Service Sam was teaching Strategy. “The early bird catches the worm”, he said in his trademark style that peppered lectures with quotes, jokes and examples. He was explaining “First mover advantage.”

Battery (he wore powerful (!) glasses) yawned. “Sir, these proverbs are meaningless.” The class was shocked. Gosh! That sort of lingo was taboo. But Battery was on a roll. “You see, an English proverb says, ‘Look, before you leap.’ And another crows, ‘He who hesitates falls.’” As the class roared in approval Sam smiled.

“If you want jargon, you shall get jargon” said Debbie. She spotted a new hairdo. Someone hissed, “Wow”. Debbie ignored the jibe and said “First mover advantage (FMA) is a firm's ability to get ahead of its competitors by being the first to market a new product category”. Phew. Flowers liked Debbie but he didn’t buy this idea of FMA. He said, “Today anyone can copy your product in six months flat. That’s all the head start you can have”. And asked rhetorically, “Then, where is the first mover advantage?”

Complimenting Flowers for his very original thinking, Sam said, “There are three reasons as to why you can create FMA. One, if you start early you will have that much more time to accumulate technical knowledge. You can then use that knowledge to beat the competition. Two, you can preempt the competition’s access to scarce assets. For example in the software industry by offering attractive pay packs and ESOPs you can stop the competition from poaching your most important asset, manpower. And finally by building an early base of customers and offering classy service you can create high switching costs”.

Debbie decided to borrow a leaf from Battery’s book. “So, it is no longer ‘he who laughs last, laughs longest’. It is he who moves first, moves fastest’? Huh”. It was all that Battery could do to keep his cool. His first mover advantage had gone! He said, “I agree with both Flowers and Sam.!” Debbie blinked. Somewhere she had read that to hold two diametrically opposite views in one’s mind and yet retain one’s sanity was the hallmark of a genius. And she knew that Battery was no genius. Mr. Power Glasses was saying, “Whether you can enjoy first mover advantage would depend on two things. The first is the pace at which the technology is evolving. And the second is the pace at which the market is expanding”.

A backbencher screamed, “Explain please.” Battery was only too happy to do that. “Technological advancements can take place at different rates. For instance, in the glass industry (which dates back to 3500 BC) the technology hasn’t changed much. In contrast, the change has been dramatic in the computer industry”. Debbie jutted in, “The faster the change the lesser is the first mover advantage”.

Battery hated interruptions. Even as he stared at her, Debbie was busy elaborating on the second point namely market: “The pace of market evolution varies from industry to industry. For instance, the market for fixed telephones developed more slowly than the market for mobiles. Landlines needed 50 years to reach a household penetration of 70%. Cell phones have cracked it within one decade. There was first mover advantage in the former (Slow market) and none in the latter (Fast market).

The professor summarized. “Gradual evolution in both technology and markets create the best conditions for generating first mover advantage. If the technology changes slowly new entrants aren’t able to differentiate their products from that of the first mover. But if the technology changes rapidly, the product itself becomes obsolete quickly. Often such products are overtaken by versions from new entrants, who are not burdened with the innovator’s dilemma, i.e., fear of cannibalizing prior investments”. As Sam paused for a sip of water, Battery whispered a translation of a local quote. “No mom likes to kill her kid!”

Sam continued. “Similarly if the market grows slowly, the first mover gets time to cultivate new market segments. The Great Depression was kind to 3M’s Scotch Tape on both fronts, namely market and technology. At first, 3M thought the product would be used in factories to seal cellophane wrapped around baked goods. Instead, it was purchased by the middle class for repairing items that in more affluent times they might have discarded! The gradual growth of Scotch Tape's appeal gave 3M the time to organize production and distribution. Technological change was also modest, enabling 3M to prevent later entrants from introducing superior versions. Scotch Tape so dominated its category that it became a generic name”.

The class heard in pin drop silence. “Sometimes, the market leads and technology follows. The Walkman, pioneered by Sony in 1979, used prevailing technologies. The basic design remained unchanged for a decade. But its market simply exploded. Yet Sony's market share was 48% even ten years after the Walkman's launch. Perhaps Sony’s superior design skills, marketing muscle and strong brand helped. Contrast this with the sewing machines industry. Elias Howe introduced the first commercial sewing machine in the late 1840s, but the machines made by Isaac Singer, a later entrant with greater resources, found more customers”.

When the technology leads and the market follows, early entrants face many years of flat sales. The furious pace of technological revolution attracts new competitors, who think their improvements will draw customers away from the incumbent. Only a company with very deep pockets can survive such a market.

Sam then asked the class, “What happens when both technology and markets change rapidly”. Battery responded, “Then first movers become vulnerable. Netscape, despite its early start, was overtaken by Microsoft”. Flowers remarked, “Hey, but look at a different example. Intel. By putting all its technical and marketing muscle behind its product development and being "paranoid" about competition, Intel dominated in its product category.” Debbie thought, “Intel inside, idiot outside.”
Service Sam was suitably impressed. He summed up: “Ultimately, let’s remember that firms should not make the first move simply for the sake of doing so. After all, first-mover advantage occurs not when a company enters a market, but when it starts making real money in it.”

From Donkey to Datsun to Donkey

2008-08-25T04:41:00.001-07:00

Wafers adored her dad. She often wondered whether a father could be any better. Now the CEO of a manufacturing major, he had handled factory operations when Wafers was a kid. She remembered the night when he took her to the factory to see how the plant worked. That night Wafers decided that she would never work in a factory! Nights are meant to be slept and not worked was her argument. “No night shifts for me”, she told herself. And hence she decided to do CA! Some original thinking indeed.

To Wafers the name Raman Roy spelt sheer magic. He, the father of Business Process Outsourcing (BPO) in India, was her new icon. To her he was the Tendulkar of business. She had read somewhere that the BPO industry was to the 21st century what the information technology industry had been to the 20th. It was offering mind-boggling job opportunities and had placed India in the global spotlight.

In a different context her professor had once told the class that geographical boundaries had begun to collapse. That the new world in which they would make a mark would belong to transnational organizations. Companies where production would be carried in one part of the world, marketing in another, design and development in a third, money would be raised in a fourth, the organization itself would be headquartered in a fifth and all routine accounting and other back office operations would be carried out in a sixth part of the world! Wow. Part six, she later learnt, was BPO.

Come July 06 when she would be a CA, should she join a BPO she wondered?
That evening as she sat with the gang at the coffee pub she poured her heart out to China. He said, “My friend works in a BPO and handles their South African operations.” “Wow,” said Wafers. “Where is he placed? Johannesburg or Antwerp?” she asked all excited. “Neither place” said Rinku, the journalist. “In fact, he works next door! Sitting in India he does the accounting work of South African clients”. China explained, “He works when it is daytime for South Africa. Between 4 pm and 12 midnight, Indian Standard Time. And there is this girl who works in their US operations. Works when it is day time for America. Between 9 pm and 9 am, Indian Standard Time”.

“Night shift” screamed Wafers. “I thought only factory workers worked night shift.”

China decided to rub Wafers. “When the outsourcing concept broke out years ago, they first outsourced transport, then security, later water service. And now Accounting! Your profession is in illustrious company.” Wafers ignored the jibe. “Its not that,” she said. “Thanks to C K Prahalad, companies are simply focusing on their areas of competence and outsourcing the rest. HR, investment banking, back office operations and IT too are being outsourced,” she added remembering what she had read the other day. And closed out saying, “The arrival of the Internet and the availability of cheap and abundant telecom bandwidth are hastening the process”. China jibed, “wisdom from the mouth of babes.”

Rinku decided to add his two bit. His dad, when he started his chartered accounting practice in the mid seventies, had gone around scouting for clients. A senior professional had then told him: “Whatever you do, do not get into maintaining books of accounts for clients! That’s a donkey’s job! You must do high end jobs; of the Datsun variety.” To Rinku, the irony was palpable. Today companies, big and small, were vying with each other to set up BPOs that essentially offered accounting services!

Wafers asked, “Do you think that a slot in a BPO company can be my first job? Will the work experience in a BPO count?” Under different circumstances Rinku would have loved to pull Wafers’ legs. Not now. “There are divided views on the subject”, he said. “One view is that a stint with a solid manufacturing company could give the right kind of grounding. After all, accounting is a staff function. An accountant should sit where the heart of the business operations, the line function, takes place.”

China supplied the other view. “Working in a BPO you get to learn how to set the right processes. Moreover, you are offering the service to global companies. So you become familiar with global benchmarks. You will probably get to know more about international accounting standards than what your course might have taught you.”

Wafers was concerned. But what about making job switches? A HR consultant had once told her, “Your first job is crucial for your career. Choosing your first job is like marriage. Marry in haste and repent at leisure. In either case there is a need for sure thought and sound knowledge.” Would she be able to later switch from BPO to say banking or manufacturing?

Rinku said, “Over time it is possible to switch from BPO to manufacturing and vice versa. In today’s world you need man management skills much more than technical skills. Moreover, in an IT driven world, skills in handling automated processes are invaluable. A BPO experience can come in handy”. China remarked, “In any case with many well managed companies trying to focus on design, brand management and other high value adding jobs and moving out of manufacturing, the traditional argument that you must work in a manufacturing company is slowly but surely losing weight”.

Wafers who wanted to work abroad because that experience would provide her the necessary fire in the belly wondered whether there would be global mobility in a BPO career. China provided the ultimate answer. “Every job is like the curator’s egg. It comes in a package – with the good, the bad and the ugly all rolled in one. You must pick up the good and learn from it”.

When they walked out of the coffee pub Wafers remembered what she had read in a magazine. That in fiscal 2004 India's BPO industry had recorded a sales of $3.6 billion and that by 2008 the figure would touch $24 billion. So far only American and British firms had outsourced work to low-cost economies, but other rich economies such as France, Germany, Italy and Japan would soon follow suit. So global mobility seemed to be very much on she told herself.

Walking into the sunset

2008-08-25T04:39:00.000-07:00

It had happened seven years ago. The year: 1998. It was an April night that Wafers would not forget in a hurry. India’s one-man army of many years, Sachin Tendulkar, had done the impossible. At Sharjah, he had lifted India from a morass to upstage the world beating Aussies. Watching Sachin bat like a genius and seeing Mark Mascaranhas physically lift the Bombay bomber in elation, Wafer had tears of joy in her eyes. That night she told herself that one day she would become as great as her hero in whatever activity she chose to do.

Today, watching Sachin fighting injury and hearing loose cannons from sundry experts about whether or not the little master should hang his bat she wondered why he had let this happen to him. Should he not have walked into the sunset at a time when people asked “Why” and not when they were asking “Why not”? Even today if he were to give it all up he would find himself a place amongst the pantheons of greats she told herself. Shouldn’t he do it? Hadn’t he already earned enough to last a few generations she wondered aloud? Or was his passion for the game so over powering?

But then, Wafers realized, that history was replete with examples of how men and women, used to the constant media glare, had found it difficult to quietly call it quits. Wafers had read of the greatest boxer of them all Mohammed Ali (of the fly- like-a-butterfly-and-sting-like-a-bee fame) who kept coming back again and again from retirement so that he could quit as the reigning champion. Of course that didn’t happen and he had to give up in disgrace. In more recent times there was Mike Tyson returning to the ring only to be hounded out by a rank outsider.

Surely Wafers would like to remember Sachin as the fighting cricketer of Sharjah than the man fighting injuries to keep a place in the team. But for every Sachin, every Ali and every Tyson there was a Martina Navratilova who had proved them all wrong she told herself.

For over two decades, beginning 1975, the grandma of world tennis had ruled the game like a colossus. When she gave it up circa 1995 she had the world at her feet. Then, some eight years later, in 2003, at age 47 she came out of retirement to compete at the professional circuit. Not surprisingly she had to eat crow losing in the early rounds making people wonder why the she was making an exhibition of herself. In the end it was she who had the last laugh. Teaming up with our very own Leander Paes she won the Australian Open. In a game where girls, half her age, retire. Wow.

Wafers’ mind wandered to politics. She had always looked upon the BJP as a party of rabble-rousers. But of Atal Vajpayee she had the highest regard. In many ways one of India’s finest prime ministers, Vajpayee, she believed, had made the cardinal sin of leading the BJP in the 2004 hustings. For an octogenarian that would mean he would be prime minister till 86. By any stretch of imagination that was a fairly advanced age to be in power. When the Congress surprisingly won the national elections and his party bayed for Sonia Gandhi’s blood (saying she should not become prime minister) he kept his own counsel letting the aura around him diminish. And when the Italian born who has made India her home gave up the chance to become prime minister it showed up our politicians as ageing men eager to have another dash at power. How nice it would have been if he had retired after his innings as prime minister thought Wafers. Oh would it not have enhanced his position as a statesman?

Of-course, Wafers thought, it is not easy to give things up. After all, there is so much of money and so much of power at stake. If you have been in the midst of public glare, it is hard to walk into the sunset. And sometimes like in the case of Navratilova it pays to come back! What a dilemma. What a dilemma.

She thought of another Navratilova, this time from the world of movies, the Big B. A brand in his own right, he gets all hearts, from the seven year-old’s to the septuagenarian’s, skip a beat. The 60 plus former angry young man has now launched into a classic second innings. Coming out of the brink of bankruptcy he had magically rebuilt his career, in a field where you are considered an oldie at forty. But for every Amitabh, Wafers remembered there were several actors and actresses with a glorious past who came out of retirement only to be consigned into the dustbins of history.

From sports, politics and movies Wafers’ mind wandered to the corporate world. There is nothing wrong in being ambitious but an attempt at an over arching reach can be killing. She thought of Jack Welch the famous CEO of GE who set out project “Next Guy” to find his successor. To her it looked like the succession would take some time in the coming. What if the legendary Welch were to slip up somewhere, thought Wafers. Should he not quit at a time when people ask “Why” and not when they start asking “Why not”, asked Wafers to no one in particular?

In stark contrast stood India’s most famous corporate czar, N R Narayana Murthy. He had handed over the baton to his chosen heir Nandan Nilekani to become Mentor and has now said that he would quit completely when he turns 60. So it is possible to quit. That is if you make up your mind.

But should you quit or not? Should you quietly walk into the sunset or not? Wafers thought she would draw up a two by two matrix, “Quits” on one axis and “Success” on the other. It would throw up four quadrants. Men who refused to quit and who bit the dust. Men who refused to quit and who hit the jackpot. Men who made successful comebacks. And men who came back only to make a fool of themselves. Ha, she realized succession planning was a tough call to take. She was still searching for answers when she realized that it was time to go to office.

Will the housing bubble burst?

2008-08-25T04:38:00.001-07:00

“Is there a Ponzi here?” wondered Wafers. She was alarmed at the housing market becoming suddenly hyper active. Property prices were piercing through the roof. There was a renewed rush for real estate. Was this for real? The one person, who could sort out here doubts, China, was busy with his semester exams. Oh, if she called him he would definitely come down to the coffee pub for a chat. The two were chums from their early school days. But she felt that it would be better if she first researched before speaking to the walking encyclopedia called China.
Wafers logged on to the net for answers. And what a veritable storehouse of information the Internet turned out to be. She learnt that in the last three years the total value of residential property in developed economies had increased by $20 trillion, to touch $60 trillion. Wow! The smart CA intern that she was Wafers quickly realized that it was a 50% increase. In contrast, global share values had risen by only $10 trillion. She noted down the first question that she should ask China “Is this housing boom sustainable? Or will it turn out to be the biggest financial bubble in history?” And more importantly, what would be the ramifications in India.
If the macro picture had stunned her, there was more of it to come in the micro scene. She learnt that it in the year 2004 prices in South Africa rose by 35%. And that in Hong Kong they jumped up by 31%. Among developed countries, Spain saw a rise of 17%, followed by France at 15% and US at 13%. Prices had jumped up at double-digit rates in half of all American states. In India too there had been a big real estate boom after a long spell of lull. Only in a few countries like Australia and Britain, house prices were now falling. Wafers scribbled Question No 2 for China: “Why do house prices shoot that way in some countries and not in a few others?”
Wafers dad had always told her to read the Economist. Today she did that and lo there were a few pointers. An article in that magazine suggested that taking the average “ratio of house prices to incomes” in 1975-2000 as a baseline, American house prices are today overvalued by almost 30%. A companion piece indicated that structural changes in an economy could justify higher real estate prices in relation to incomes. For example, real interest rates in Ireland and Spain came down sharply when they became members of the Euro zone. But lower interest rates cannot explain all of the surge in house prices crowed another article. For Wafers things were beginning to get a bit hazy!
She clicked the mouse and landed on an information goldmine. A blogger had written, “The current global housing boom is unusual. Never before have so many countries had housing booms at the same time”. The World Economic Outlook had the IMF playing Dr. Doom. It carried a warning that just as the upswing in house prices was global, so would the downturn. The IMF offered some statistics to back its claim. It seems that between 1991 and 2004 the Japanese property prices had dropped every year by a total of 35% from their peak in 1991. Yet the 36% rise in real house prices in Japan in the seven years between 1984 to 1991 was less than the increase over the past seven years (1997-2004) in most of the countries that are seeing a boom today. Even Wafers with her flair for numbers was finding this numbing. She admired these statisticians. Her professor had once famously told the class that “A statistician is a person who when he has one foot on a hot stove and another on ice cold water concludes that on an average he is comfortable.”
Even as her thoughts wandered along those lines she remembered her professor speak highly of a certain Alan Greenspan. Ha, the big boss of US treasury. And here he was quoted on the Internet giving a spin different from that of the IMF. Greenspan claimed that the growing concerns about an American housing bubble are exaggerated. His argument was that the housing market is less prone to bubbles than the stock market, because home owners cannot buy and sell their houses as easily as speculators can buy and sell shares. People have to live somewhere and large transaction costs discourage trading in houses. Nice argument, Wafers told herself; but she wasn’t exactly convinced.
She wondered, “How would China respond to Greenspan’s point?” Ha, the answer lay in Economics. Greenspan or no Greenspan bubbles can develop in housing markets, as well she told herself. That’s because of imperfect information. Her argument was simple: “No two houses are alike. There is no central exchange where property prices are determined every second by the forces of demand and supply. (Ha, “the two blades of the scissors”, her Economics teacher had sounded out.) And there is no short-selling in the real estate market. When bullish investors push stock prices up, the price rise might get moderated by other investors selling short in the hope of buying more cheaply later. Nothing like that happens in real estate. Buyers' expectations about future house prices tend to be based on recent trends. So a rise in prices will boost demand further. Banks also unwittingly encourage bubbles as they have an incentive to lend heavily when property prices rise. This pushes prices even higher. But when prices fall, banks pull out, amplifying the fall”. She patted herself and told that even China would be impressed by her logic.
Wafers believed that in India house prices were getting unrealistic. She remembered her friend from Hyderabad. He had said that a flat which fetched a monthly rent of Rs. 7000 costs Rs. 25 lakh. The EMI (Equated Monthly Installment) on a 15 year loan of Rs. 20 lakh for that flat worked out to Rs. 18,000. Surely it made more sense to rent than to buy a house. Many people were buying property, in the hope of capital appreciation. Her friend had argued that people were looking at housing less as a place to live in and more as an investment. If selling pressures increased as investors tried to book profits, the bubble might well and truly burst. If that happened, the consequences can be catastrophic. Wafers knew that once China’s exams were over she would have to invite him for a cup of tea to get more answers to these issue

The Flat tax

2008-08-25T04:37:00.000-07:00

The B-School had invited a star tax practitioner to talk to the Class of 2006 on the basics of taxation. It was an opportunity which the CA grabbed with alacrity. He had always believed that the syllabi and students at the B-Schools had “style but no substance”. He would show them up for how shallow they were. As he walked into the class looking extremely prosperous, all suited and booted, the class rose up in awe of the man the nation called TP. No one really knew where the name came from; but it had stuck.

Fifteen minutes into the class as TP spoke to a spell bound audience, the first crack in his armour began to show up. He was speaking on “entry level”, “maximum marginal rate” and the “incidence of tax” with a healthy sprinkling of wit and wisdom. He told them that as good citizens we must pay our taxes. It was then that Boka set the cat amongst the pigeons. “Sir, Taxation in India has become far too complicated for the average Indian; yet tax is too important a subject to be left exclusively in the hands of the tax experts.” TP smiled. All his life he had made his money thanks to India’s complex tax system. And here was a rookie who wanted to change all that.

“Why can’t we have a single tax slab? Say, tax everyone at 20%? Why should we have three slabs 10%, 20% and 30%” asked Debbie, the baby faced lass, who loved simplicity. “Not to speak of a surcharge that adds insult to injury” remarked Goggles. “You mean have proportional tax and not graduated or progressive tax?” asked Flowers. Seeing a few eyebrows raised, Flowers took it upon himself to elaborate. “A flat tax, (a k a proportional tax) is a system that taxes everyone at the same rate viz a proportion of income. In contrast, under progressive income tax citizens with higher incomes pay tax at a higher rate than those with lower incomes”. A tax is an involuntary fee paid by individuals or businesses to a state, or to functional equivalents of a state, including tribes, secessionist movements or revolutionary movements. ... Citizenship is membership in a political community (originally a city but now a state), and carries with it rights to political participation; a person having such membership is a citizen. ... A corporation is a legal entity (distinct from a natural person) that often has similar rights in law to those of a Civil law systems may refer to corporations as moral persons; they may also go by the name AS (anonymous society) or something similar, depending on language (see below). ... A progressive tax, or graduated tax, is a tax that is larger as a percentage of income for those with larger incomes. ... Income tax is a direct tax which is levied on the income of private individuals. ... A progressive tax, or graduated tax, is a tax that is larger as a percentage of income for those with larger incomes. ...

Debbie remembered someone speak at a debate saying that there was a time in India when the maximum marginal rate was 97.5% and that in addition you had to pay a wealth tax of 5%! That is, for every rupee that you earned beyond a point you paid approximately 98 paisa as tax. And of whatever little was left you paid wealth tax. God why would one want to earn, the speaker had thundered.

“Sir, does any country adopt flat tax” asked Debbie. Before TP could open up, Flowers was quickly off the block. “Eleven years ago, in 1994, Estonia became the first European country to introduce a “flat tax” with a uniform rate of 26%. Latvia (25%), Lithuania, Russia (13%) Slovakia (19%), Ukraine (13%), Serbia (14%), Georgia (12%) and Romania (16%) soon followed suit”. Boka offered an explanation. “The flat-tax movement has hit off in the erstwhile communist countries because these countries were starting from scratch in choosing a tax code and they opted for the one that was simple and efficient”. TP was beginning to have second thoughts over his “all style and no substance” argument.

“Why would you think that flat tax is convenient,” asked TP. His tone may have conveyed annoyance but it was a put-on to get the best out of the group. Goggles said, “I read somewhere that in the US the cost of administering progressive taxation is about 10% to 20% of revenue collected”. Boka offered him support. “Flat tax is an administrator’s joy. As every Rupee is taxed at the same rate, the taxman is not bothered about who is being paid how many rupees. He can simply withhold 20% of a company's payroll, without being concerned about individual pay packs.” Debbie closed out, “But if a second rate of tax is added, the tax collector has to find out how much money is going to whom before he can be sure of collecting the right amount from the right person!”

“Any specific examples” asked TP. Ah, he hadn’t counted on his wards’ wide ranging reading habits. “Flat tax can yield good results,” said Flowers. “When in 1994 Estonia repealed its high tax rate on the rich it did not hurt the tax base. Actually that year the revenues rose to 40% of GDP. Ditto in 2002. The country now plans to cut its flat rate from 26% to 20% by 2007”. Debbie remarked, “Sir, in Russia in the year 2001, the government combined its 12%, 20% and 30% personal income tax bands into a single 13% rate. A year later tax collections were up by 26%”. “Flat and up” closed out Flowers.

Boka decided to offer his spin to the Russian experience. He said, “Flat tax is simple. The government's revenues surged not because the Russians suddenly started working hard, but because tax administration and compliance became easier. So if flat tax is to be introduced in a country, the idea should be sold on the simplicity plank.”

“Well, what is wrong with progressive taxation” asked TP. “Is it not wiser to make the rich give up a bigger share of their disposable incomes? Doesn’t a flat tax violate this principle?” he asked rhetorically. “No”, said Debbie. “A flat tax usually combines a threshold (that is, an exempt amount) with a single rate above it. The system can be made progressive by playing around with these two variables”. Wow! Goggles drove another nail, “A flat tax increases the incentive to work, unlike a progressive tax, which discourages extra effort from society's best-paid members. Sir, a graduated income tax is graduated robbery.”

Neta, the guy with political ambitions, decided to stand up and be counted in the dying moments of the class. “In India we need radical tax reforms. So far we have been playing at the fringes. Our Income Tax Act needs to be cut down by half. A flat tax will provide the answer. Okay, the leftists might make noise but the tax’s sheer convenience and ease of administration hold out the promise of a clean and transparent system, which India badly needs”.

The only thing that the class hadn’t mouthed was Adam Smith’s canons of taxation thought TP. As he got ready to respond to their arguments, the gong went.

Of flannelled fools and other games.

2008-08-25T04:36:00.001-07:00

“Cricket must be banned,” said China. He was biting his pasta and flipping through the latest copy of the Outlook magazine. Wafers, whose love for cricket was second only to her love for CA, almost dropped her glass of coke. “Why?” she screamed. She knew that China wasn’t a guy given to eccentrics. And she wanted to hear out his reasoning for she felt was an absurd statement.

“Indians are crazy about cricket and cricketers. Ditto with movies and movie stars,” China purred. “So what’s your problem?” asked Wafers. His eyes still on the Outlook article, China said, “The silly game has become an industry and the Board of Control for Cricket in India (BCCI) is awash with money”. Wafers blood pressure rose. “So?” she asked. China simply said, “It is not good for India”. Stupid engineer, thought Wafers. He gets subsidized education at IIT, plans to work abroad at a fancy pay package and now talks about what is good for India.

China could read her mind but refrained from being drawn into that debate. Instead he said, “You understand economics. So let me explain in the language of the economist”. Big deal, thought Wafers. She didn’t like grand standing. “Economics,” said China, “talks about negative externalities and market failure. The market economy tends to overproduce goods and services that have external costs. Cricket falls in this category. While the BCCI and the Indian cricketers are laughing their way to the banks, they are imposing costs on society”. Wafers couldn’t digest anyone rubbishing her favourite game. And so asked, “How?”

Stuffing another piece of pasta into his mouth China said, “Look. Work suffers in many offices while matches are being played. In cities like Calcutta work comes to a standstill. Worse still, far too much time is wasted on highlights and post mortems by self styled analysts. The amount of output lost clearly exceeds the value created by the game!” Wafers couldn’t help saying, “Boy, this is a democratic country. We do what pleases us. You can’t play the big brother.” The captain at the table joined the debate. “He pumped for China. There are other issues as well. Today, everyone talks about the need to be globally competitive. But, cricket is neither a global game nor is the Indian team truly competitive!”

“Crap” said Wafers. “Are we not proud of a marauding Tendulkar? Does our sense of patriotism not shoot up when India wins a match?” she asked. China smiled. An angry Wafers was always a treat to watch. “In the developing countries where cricket is played, it is some form of diversion from the more pressing problems of life. When Sri Lanka won the World Cup it was to them a great escape from the socio-economic problems that was ravaging their nation”. The captain nodded and said, “In the few developed countries which play cricket like Australia, New Zealand and England, cricket is not the national game”. China rubbed in. “So, terms like ‘world champions’ are a misnomer when it comes to cricket. Olympic winners are the real world champions. For, they compete against the best in the world”.

China wasn’t through yet. “Why do people play sports? Because it promotes physical fitness. But cricket does no such thing. How many of our test cricketers can really run fast? And the game isn’t strenuous. Only the wicket keeper’s job is physically demanding. That job alone is comparable with that of an athlete”. The captain bringing in a pack of French fries for Wafers said, “And it is not a coincidence that we have failed to produce a good wicket keeper in the last 15 years!” Wafers couldn’t help thinking, “Strangely enough, people responsible for cricket in India have decided that a specialist wicket keeper is not necessary”.

Wafers was beginning to feel converted. She couldn’t help recall what her kid brother had said the other day. “If India keeps winning consistently the way Australia has done in the past many years, it would be great”. Yes, India is some 8th in the test rankings with only the minnows behind it, Wafers remembered. And also that when India finished runner up in the World Cup it had been walloped by a huge margin by Australia. As China had then remarked, “We finished a distant second.”

Wafers couldn’t let down her heroes. She thundered, “You guys are jealous that the cricketers make money. As if you folks don’t like the smell of currency.” Why grudge them? China responded. “Look that isn’t the issue. Cricket is diverting scarce resources away from games which are more appropriate for our country. Take hockey. Many developed countries play hockey. So winning the Olympic gold in hockey is an achievement. Further, hockey is played for about 90 minutes in the evenings. It does not disrupt office work. And it demands tremendous physical fitness.

Once world beaters in hockey, today we are the whipping boys. Reason: Lack of incentives. While our cricketers fly around the world with their wives and drive in imported sports cars (on which customs duty is waived off), our hockey players travel by rail in second class compartments”. The captain at the table said, “Recently, I saw a former Olympics hockey player who had come to inaugurate the sports days at a school. I was pained to see the kind of respect given to him. If he had been a test cricketer, he would have been pampered beyond imagination”.

Wafers was beginning to feel that the China and the captain might have a point. China drove the final nail saying, “If the Indian cricket team were a listed stock, no one would touch it with a barge pole. Reason: The theory of valuation suggests that the value of a stock is the present value of the future cash flows. And neither the Indian cricket team’s present performance nor anticipated future performance is anything to write home about”.

Wafers was stumped. She remembered a Bernard Shaw quote, “Cricket is a game played by 11 flannelled fools and watched by 11,000 fools.” She decided to have her sip and give a quick slip. Disgusted. Disappointed. And as usual confused.

Qayamat se qayamat thak

2008-08-25T04:35:00.001-07:00

Wafers had a problem with her Accounting Standards. She decided to surf the net to find a solution. And lo, she ran into the arresting story of Charles Ponzi. The dapper Italian immigrant had landed in the US in 1903 and in the years ahead had become enormously famous for the wrong reasons!
The story ran thus: Ponzi launched an export magazine and, among others, invited a person in Spain to subscribe to it. The subscriber sent Ponzi an international postal reply coupon. This coupon could be exchanged at the American post office for the American stamps that were needed to dispatch the magazine to Spain. The coupon in Spain cost the equivalent of one American cent. In America when Ponzi exchanged the coupon, he got six cents worth of stamps! Sensing a huge arbitrage opportunity, Ponzi decided to float his scheme in 1919.
The scheme promised to double investors’ money in 90 days flat. Little wonder, money started pouring in. Ponzi’s plan was to raise American dollars, convert them into foreign currency, buy international postal reply coupons from various countries including Spain, convert them into American stamps and sell them for a windfall. So far so good. But on 10th Aug 1920, Ponzi defaulted and most investors lost their shirt. Investigations revealed that only two stamps had been purchased! The early investors had profited -– but that was because money brought in by the new investors was used to pay off the earlier investors!
Wafers was very excited when the following day she met China at the coffee pub. She knew that for once she would score over him. “Have you heard of Ponzi?” she asked. “You mean Charles Ponzi?” replied China, stumping Wafers for the nth time. “Does this guy know everything?” wondered Wafers. China interrupted her thoughts saying, “You see, there are many Ponzi schemes in India. Actually, there is one which is now circulating that gives you an opportunity to make Rs 149 lakh on an investment of Rs 10,000! Here’s how”.
“You become a member of ‘the club’ by buying a membership form for Rs 10,000. To recover this Rs 10,000 you canvass to enroll four new members to the club. Let us call them Patron A, Patron B, Patron C and Patron D. Each of the patrons will buy a club membership form for Rs 10,000. The Rs. 10,000 is paid through a demand draft in the following manner. Rs 2,500 to the person who canvassed to enroll their patron member. Rs 750 to the club. Rs 500, Rs 750, Rs 1000, Rs 1250 and Rs 3250 to the person whose name appears in Rung 5, Rung 4, Rung 3, Rung 2 and Rung 1 of the club membership form respectively”. The smart CA trainee that she was, Wafers took in all the numbers in one go. She wasn’t foxed.
China continued, “The moment you enroll the four Patrons you have recovered your Rs 10,000. Patron A (so will Patrons B, C and D), to recover his Rs 10,000, will canvass to enroll four new members. Let's call these new members as Layer 1 members. When these Layer I members (there will be 4 X 4 = 16 of them) receive the club enrollment form they will make the payment in the manner indicated above. Your name will appear in Rung 5 in their form. That is, they pay Rs 2,500 to Patron A (Patron B, C or D as the case may be), Rs. 750 to the club, Rs 500 to you and the other indicated sums to the persons whose name appear in Rungs 4,3,2, and 1 of the form. When Layer 1 members canvass to enroll four new members each, it generates 64 Layer 2 members. Your name moves up to Rung 4 in the club membership form which the Layer 2 members receive. And you will receive Rs 750 from each of the Layer 2 members”.
Quick on the uptake, Wafers realized what was on. She said, “Layer 2 members now canvass to enroll 4 new members. This generates a total of 256 (64 X 4) Layer 3 members. When Layer 3 members buy the club application form, my name would have moved up to Rung 3. And I would receive Rs 1,000 from each of these members. Layer 3 members then enroll four new members each and thus generate 1,024 new members. And when these 1,024 Layer 4 members buy the forms my name moves up to Rung 2. I receive Rs 1,250 from each of them. Similarly, when the Layer 4 members canvass four new members each, it generates 4,096 Layer 5 members and my name moves atop the rung and I collect a cool amount Rs 3250 from each of these Layer 5 members”.
China was impressed. “Bravo, Wafers”, he said. And added, “After this you cease to be a member. If all the members, from Patron to the Layer 5 members, could enroll 4 new members you stand to pick up a cool Rs 149 lakh. This is how it goes. From Patrons (4 @ Rs 2,500 each) Rs. 10,000/-. From Layer 1 members (16 @ Rs 500 each) Rs. 8,000 /-. From Layer 2 members (64 @ Rs 750 each) Rs. 48,000/-. From Layer 3 members (256 @ Rs 1,000 each) Rs. 256,000/-. From Layer 4 members (1024 @ Rs 1,250 each) Rs. 12,80,000. From Layer 5 members (4,096 @ Rs 3,250 each) 133,12,000/- Total Rs. 149,14,000”.
Suddenly Wafers looked suitably confused. “Look, I do not lose money as long as I enroll just 4 new members. Isn’t that right? So what’s Ponzi in the scheme?” she asked. “Well, that’s the Ponzi,” said China, tongue firmly in cheek. “As the number of members snowball, those who join late may find it increasingly difficult to collect 4 new members and could hence lose out. Remember close to 90 per cent of your Rs.149 lakh is brought in by the Layer 5 members. Or, if the club, which makes nearly Rs. 41 lakh on every full circle closes shop, all those who are yet to enroll their quota of new members lose out”.
It hit Wafers like a lightening. “So, the success of Ponzi schemes lie in the fact that they appear to be a genuine investment opportunity?” she asked. China replied, “Yes. People running Ponzi schemes understand human psychology. They know that the public wants to live up to the Joneses. Because their neighbour made money on a Ponzi these guys too want to. When the rest of the world is going mad, the investors must imitate them to some extent!” For once, Wafers matched China word for word. “There are other reasons as well, I suppose. I think everyone wants to become rich. The rich want to become richer. Even the richest people are at Level I of Maslow’s hierarchy!” China remarked, “First there is greed. Then there is the individual’s belief that no one can defraud him. Over confidence and over optimism together fuel Ponzi Schemes”.
Wafers had the last word. “A Ponzi scheme can keep running only till the money entering the scheme is more than the money leaving it. At some point the bubble bursts. Then the money flow dries up. And presto the scheme folds up”.
The captain at the table overhearing the conversation said, “So from 1921 to date investors have elected to be robbed! Qayamat se qayamat thak”.

Improving responsiveness to Supply chains

2008-08-25T04:34:00.001-07:00

Wafers had attended the morning class on “Just in time” (JIT) management. The good professor had sounded out that the world had long ago moved out of the EOQ model and was today dating JIT. Wafers wasn’t willing to buy that argument. Her logic was simple: In JIT, the manufacturer was merely pushing his problem on to the supplier who in turn was pushing it on to his supplier. The buck had to stop somewhere. Wafers did not have the heart to voice her concerns to the professor because the class was too busy cracking some quantitative problem on JIT.

That evening as the gang met up at the Chennai Coffee Pub, she aired her concerns to China, her smart pal who studied at IIT. “Oh, you mean the crisis on the supply chain front,” he cracked. “Wow! These guys can give fancy names to mundane stuff” thought Wafers. She did not know what she was getting into. At the end she would realize that she hadn’t really bargained for what was to follow. China explained, “You are right. A supply chain must be very responsive to changes in market demand. Otherwise companies can be left with unsold inventory which may severely dent the bottom line.” China had read Wafers’ mind. It stumped her no end.

Rinku, the journalist, looking disheveled after chasing a breaking story, quoted the case of a global company famous for its supply chain management. “In April 2005, the company had surprised the world, when it wrote off a whopping $4 billion dollars of surplus raw materials. It was amazing that the global major had misread demand by such a mile.

China explained how the trouble had arisen: “The problem lay in the behavior of the supply chain partners. The company out-sources a massive part of the production activity to contract manufacturers. Before the crisis erupted, the contractors had piled semi-finished products because demand for the company’s products had always exceeded supply. Remember, the company rewarded the contractors for prompt delivery. So the contractors had an incentive to build buffer stocks. Many contractors did bulk purchases from component suppliers to pick volume discount and thereby increase their profits. Therefore, both the contractors and component makers had everything to gain by building excess inventory.”

When demand slowed in 2005, the problem which had remained hidden so long, now surfaced. Most contractors simply assumed that the company would buy everything they could produce. Since the company had not stipulated the responsibilities of its contractors and component suppliers, much of the excess inventory ended up in the company’s warehouses. The company landed in trouble because its partners acted in ways that were not in the best interests of the supply chain.

Rinku took over to explain the lessons. “While building supply chains to deliver goods to consumers, one must understand the behavior of the various firms in the chain. Every firm seeks to maximize its own interests thus undermining the functioning of the entire supply chain. The risks, costs and rewards of doing business must be distributed fairly across the network. Misaligned rewards cause excess inventory, stock-outs, incorrect forecasts, inadequate sales efforts and sometimes poor customer service.”

China explained that incentive-related issues arose in supply chains arose mainly because incentive schemes were also badly designed. He then decided to illustrate with an example.

“There is this ferroalloy exporter operating from Visakhapatnam port. The ferroalloy is manufactured at a factory 150 km away from the port. Movement of the ferroalloy takes place by truck. This job is outsourced to a transporter who hires trucks. The transportation contract is fixed on a per ton basis which would be unaltered for a year. The transporter, however, goes into the market daily and hires trucks based on the prevailing market rate. If the rate is not lucrative, he doesn’t hire any truck. Because of the inability to move cargo, shipments get delayed. So it makes sense for the exporter to pay the transporter on the basis of a spot rate plus mark up”.

“But truck contracts are never structured this way because there is lack of trust. Like, there are difficulties in verifying the rate at which the transporter places the truck. So managers want to play it safe and offer long term contracts.” As China sipped into his 4th cup of coffee, Rinku took over. “A second point is that since transporters are paid on a per ton basis, they have no incentive to place a truck if there is a part load. This is because the truck owner (the third one in the supply chain) will charge for a full truck even if it is only partially loaded. So the transporter doesn’t carry out the customer’s instruction to hire trucks immediately. Rather, he would wait for a few days to ensure that enough stock has accumulated.”

Wafers asked, “How does one crack the conundrum?” China replied, “Firstly companies must acknowledge that there is misalignment in incentives. They must then redesign incentives to obtain the behaviour they desire from their partners. Only managers who understand the motivations of other companies in their supply chain can tackle incentive-related issues. Since alignment also requires an understanding of functions such as marketing, manufacturing, logistics, and finance, senior managers must get involved in the process”.

Wafers wasn’t convinced: “But how do you think alignment of incentives is possible?” Rinku responded, “Contracts can be framed that reward or penalize partners based on outcomes. Thus transporters can be penalized heavily if they do not place trucks on time and rewarded handsomely if they do so.”

Wafers wasn’t sure whether she was any the wiser but realized that there was a lot more to business than what her CA program had taught her.

What makes a good decision?

2008-08-25T04:33:00.001-07:00

“What are the different types of decisions?” asked Service Sam, stunning the class. Sam never asked inane direct questions. But then he was the boss and the boss has the right to handle sessions the way he chooses!

Goggles offered a frill free answer. “Decisions can be classified into strategic, tactical and operational, depending on the type of impact they make. Strategic decisions are irreversible and have long term implications. These decisions must be made with the active involvement of the top management. Tactical decisions have medium-term implications. They convert strategy into action. Operational decisions have a short term impact and can be reversed with ease. Such decisions do not need the involvement of top management. In fact top management should be freed of this burden, so that they can spend more time on strategic matters”.

“But, Sam, the ground realities are different” said Debbie, the baby faced, pony tailed, topper. “In Indian companies the involvement of senior management in decision making defies Goggles’ logic. In one organization, in which my cousin worked, buying a management book costing Rs. 800 needed the approval of a senior manager. But a junior officer could place a Rs. 5 lakh order on a transporter to move cargo from the factory to the port”. The class smiled.

Flowers, with three years of work experience behind him said, “In the company where I worked, going on a tour which cost Rs. 30,000 was considered operational; but getting a nomination for a training program which cost Rs. 5,000 was viewed to be strategic”. Sam agreed, “There are no black and white rules while categorizing decisions”.

Sam then decided to take the discussion to the next level. He quoted Peter F Drucker. “The time and effort spent on a decision should be proportional to its importance. Important decisions should consume more time compared to unimportant ones”. Drucker might have been a management guru but the class felt that he was off the mark when it came to Indian companies.

Debbie chirped, “In most Indian organizations, the way decisions are taken has little to do with their importance. When taking decisions, the real concern of managers is how they will be perceived by their bosses. Managers want to take decisions in such a way that they do not have to assume much risk”.

Flowers said, “When middle managers have to take decisions on matters which do not go through a serious vetting process, they are fast. But when the decision has to be approved by the boss and a strong business case has to be prepared, they go slow. They are apprehensive whether they will be able to sell the decision to their bosses. They feel that any proposal which is rejected by the boss will diminish their career prospects”. Boka added, “Managers spend a lot of time doing things which make them happy and virtually no time on those which cause stress and discomfort. In the process, they turn decision making into a complete farce. Without actually taking decisions, they fool themselves into believing that they are doing so”.

“Unfortunately, all good decisions are inherently risky. And they involve a lot of effort and discomfort”, said Goggles. “Illustrate” screamed the class. “I hate personal examples, but I shall make an exception this time.” It was Boka playing to the gallery. “Years ago, when Chittaranjan Locomotive Works (CLW) was in its formative years, Telco (now called Tata Motors) was a major equipment supplier. CLW always sent its engineers for inspection to the Telco factory before taking delivery of the equipment. Once there was a crack in one of the equipments and the CLW engineer promptly rejected it.”

“When the Tata management expressed their concern to CLW, CLW decided to send my late grandfather, (then a Railway engineer on deputation to CLW) to inspect the machinery. Grandpa quickly realized that rejecting the equipment was a safe decision that did not call for any effort or risk. But effectively, it was no decision. The real decision was in telling Telco engineers how to rectify the defect so that both CLW and Telco would benefit. Such a decision involved risk. If something went wrong, grandpa would be held accountable. But, if the decision proved right, he would not gain in any way, in a system where there were no incentives for high performers. But my grandfather decided to go ahead with what he felt was right. An expert in welding, he quickly specified the kind of welding to be done to repair the crack. Working with the Telco engineers, grandpa ensured that the equipment was made fit for delivery. Telco’s top management was so impressed with him that they promptly made him a job offer. But the committed railway man that he was, my grandpa promptly refused the offer. That, however, is beside the point”.

Sam nodded his head in appreciation. “What Boka’s story indicates is that in most business situations, managers can take two decisions, one which is riskless and effortless and the other which is risky and effort intensive. Dropping a new investment proposal is an easy decision but making the investment and taking the proposal forward is a tough one. Promoting a young, bright manager is a difficult decision but denying him promotion on the basis of seniority is an easy decision”.

Flowers remarked, “In well managed organizations, managers do what they think should be done without worrying about how they as individuals will be perceived. The top management tolerates failures as long as the reasons for the failure are beyond the control of the managers”.

Realizing that the gong was about to go, Sam decided to close out. “To encourage better decision making, top management must lead by personal example. They must walk the talk. They must encourage people to take decisions unmindful of possible failure”. He then asked, “You guys love cricket, don’t you?” “Yes”, screamed the class. Sam said, “Who can ever forget Kapil Dev running across the field at Lord’s to take Viv Richards’ catch. That catch, which looked impossible when Kapil started running, effectively won India the 1983 World Cup. A mediocre fielder would never have attempted it. And no one would have really faulted him!”

“To encourage managers to spend more time on the ‘right’ issues, experimentation must be encouraged. Failures should be punished only if they have been made due to avoidable negligence or bad planning. Employees who stick their neck out, and walk the extra mile, must be rewarded handsomely”. The gong went.

Principal-Agent conundrum

2008-08-25T04:32:00.001-07:00

Chatshow was handling one of the final sessions on corporate finance. He was explaining to the class the principal-agent tiff. While textbooks talked about the principal agent relationship in their opening chapter, the mercurial professor had intentionally held it back till the end because he ardently believed that all introductions should come at the end! His take was simple: only after the students had appreciated the gravity of finance would they be able to appreciate what finance deals with. Some original thinking indeed!

Walking up and down the aisle, (the class called it Chatshow’s catwalk!), Chatshow said, “Agents, often pursue goals which are different from those of the principal. So, agents have to be enticed to act in the best interests of the principal.” Boka jumped the gun and asked, “Sir, any examples?” Chatshow turned silent and looked at the class – an indication that they must respond to Boka’s query.

Flowers’ hand went up immediately. “The share holder of a bank is a principal; the managers are the agents. The goal of the bank’s shareholder (principal) is to maximize the bank's profit. But the bank's profit depends on the actions of its managers (agents) who have their own goals. A manager may take a customer to dinner on the pretense that he is building a relationship with him, when in fact he might simply be having a ball”. A backbencher whispered, “Hey anyone here whose dad is a banker?”

Even as giggles broke out, Goggles chipped in, “In relation to the teller, the manager acts as the principal. He would like the customer to have a minimum queuing time whereas the teller (agent) might like to spend more time with the customer to have his problems resolved”. Flowers’ felt that these weren’t the savviest of examples. Nevertheless the discussion had gathered momentum.

Chatshow stepped in: “The principal-agent conundrum lies at the heart of corporate governance. The interests of the shareholders and managers do not converge.” Boka who had done some work on corporate governance for his summers said, “The agency problem is complex. Just giving orders and attempting to make employees obey them won’t do. In many cases, it is not possible for the shareholders to monitor the managers or even for the managers to monitor the employees”. Flowers, who fought for grades with Boka, nodded. And then added, “To achieve their goal, the firm's owners (principals) must induce the managers (agents) to work in the company’s interests. And in turn the managers (principals) must induce the other employees (agents) to work efficiently”. Well said; but how was it to be done.

Chatshow offered some perspective. “Each principal attempts to get things done by creating incentives that induce each agent to work in the interests of the principal. Behavioral scientists call this goal congruence. The goals of different stakeholders like employees, managers and owners must be aligned”. He then asked, “Folks, how do you think this can be done?”

The class had read about CEOs drawing fancy salaries. And of how the previous batch had drawn an average salary of one million INR. They understood the language of money. Goggles, whose dad was a hotshot CEO, said, “We can issue stock options. By giving employees a stake in the business, it is possible to imbibe in them a feeling of ownership. This would lead to better performance on the job, leading to higher profits and hopefully greater market capitalization.”

The girl in the middle row (she always sat there and was so dubbed GITMR) pointed out, “We should look at incentive based pay for everybody. For example, managers can share in a firm's profits for meeting profit targets, and employees may be given bonuses for meeting production or sales targets. This will motivate them to maximize output and sales.” The baby-faced topper Debbie interjected: “Another option is for principals to appoint a group to monitor the actions of agents more closely. For example, shareholders, despite being owners, do not have the time or the competence to monitor the functioning of the company. They therefore appoint the board of directors to act as trustees and impose checks and balances on the managers.” Chatshow was impressed at the simple solution.

It was at this point that Boka brought in a dissenting view. “But will these measures really solve the problem?” he asked. “Managers may manipulate profits. They may window dress the financial statements. They may not invest sufficiently in long gestation projects, which will deliver profits only in the long run. They may drive the plant too hard to maximize production without investing in maintenance” he offered by way of elaboration. GITMR saw the point and said, “With profits going up, their incentives will go up. The stock price may move up temporarily, as the markets will not be privy to the private information managers have about the exact state of affairs in the company. This will enable managers to encash their stock options. But in the long run, the shareholders of the company will be put to disadvantage.” Flowers remembered what he had heard from his seniors. That the B-School’s placement officers when given the option of placing one graduate at Rs 9 lakhs per annum and two at Rs 5 lakhs each had plumbed for the latter because their incentive pay was based, among other things, on how many students were placed!

Neta who aspired to be a politician, pointed out: “Both in India and abroad the agency problem looks intractable. See what has happened at Hewlett Packard (HP). HP’s CEO, Carly Fiorina, merged HP with Compaq to create an empire that would rival IBM in size. She forgot the cultural differences between the two companies. She greatly exaggerated the synergies. And while trying to achieve them, she questioned many of the core values of HP, thus rubbing several employees on the wrong side. Many good employees left HP. Consequently, the merger bombed.” Debbie who had read that piece added, “Recently, Fiorina was sacked by the board for failing to reward shareholders. But going by press reports it would seem that the lady has lost little. She was given an attractive severance package of about $21 million and is now in contention for the post of World Bank president!”

The gong went. And Chatshow was happy at not just igniting a discussion but in once again realizing that his wards had their finger on global events.

Cut, Copy and Paste.

2008-08-25T04:31:00.001-07:00

“If you copy from one source, you are guilty of plagiarism. If you copy from several sources you are lionized for researching.” As the class smiled, at his borrowed witticism, Service Sam added, “Ladies and Gentlemen, I want neither”. Did he want neither ladies nor gentlemen to be present in the class or was he wanting neither plagiarism nor research wondered Debbie, the baby faced topper.

It was then that the professor dropped his bombshell. “Folks, your summer project reports must be hand written, not word processed!” Sam was known to go bonkers but Boka felt that the professor had exceeded even his known levels of eccentric behavior. “I dislike cut-paste jobs,” said Sam, offering it as some kind of explanation for his bizarre requirement. At the B School everyone understands cut-paste. Professors equate it to copying. When a new book appears in the market, people are known to remark, “It is a cut paste effort”. When someone turns out to be a prolific writer, people mention that he is good at doing a ‘cut paste’ job.

Sam went on to mention that if the option to “cut-paste” existed, the credit had to go to Microsoft, the global software giant. When working with Microsoft applications, one could ‘cut’ a portion and ‘paste’ it wherever required, in the same file in the same folder, in a different file in the same folder or in a different file in a different folder. While working on a LAN, one could cut paste entire folders from one address to another. But today, the term has negative connotations. Phew.

Boka felt that Sam was throwing the baby along with the bath water. Not just that. He felt that there wasn’t anything really wrong with cutting and pasting. And that, down the ages, people had been rewarded for this play. “Sam, I disagree with you. Look, even innovation isn’t invention”. The class sat up. Boka taking on any professor was always a treat to watch. “Come again,” said Sam, a shade irritated.

Flowers (because he always wore a flowered shirt) decided to join the slanging match. “Sam, innovation is less of serendipity and more of systematic hard work,” he said. A backbencher sounded out, “Genius is 1% inspiration and 99% perspiration”. Goggles (because he always wore Goggles outside the class) had an engineering background and quoted Louis Pasteur, “In the field of observation, only chance favours the prepared mind.” Debbie jumped in, “Innovation is usually not about radical breakthroughs. In fact, it is often about lifting an idea from one context and applying it in another”. Boka supported her: “Innovation is about taking a tried and trusted technology to a new market or bringing a new technology to the existing market. It is about applying what has worked in one industry, in another”. Flowers closed out, “in short, the basic approach to innovation consists essentially of “cutting and pasting.” Even the great Thomas Alva Edison did exactly this”.

“Proof,” said Sam. He believed in facts and examples rather than pompous arguments. The class of 2006 was ready for it.
Goggles added, “Sam, serious research work in management takes place by “cutting” an existing methodology in one context and “pasting” it in another. It can also happen by “cutting and pasting” a new methodology on an existing database. Event studies developed by the great scholar in the area of finance, Eugene Fama, have been “cut and pasted” in several applications of management. Similarly, game theory has been “cut and pasted” in several research studies.” Sam wasn’t pleased. “Specifics, specifics” he said.

Flowers mentioned, “Edison's inventions were not entirely original. They were extensions and blends of existing knowledge. Edison’s team used its knowledge of electro-magnetic power from the telegraph industry, where they first worked, to transfer old ideas that were new to the lighting, telephone, phonograph, railway, and mining industries. The phonograph blended old ideas from products that these engineers had developed for the telegraph, telephone, and electric motor industries. Edison’s laboratory’s work on telegraph cables later helped its engineers transform the telephone from a scratchy-sounding novelty into a commercial success”. Sam had to agree reluctantly. After all, it was he who had in a different context applauded Edison for delivering on his promise of “a minor invention every ten days and a big thing every six months or so.” In six years of operation, Edison’s team had generated more than 400 patents.

Debbie stepped in. “The steam engine was used in mines for 75 years before Robert Fulton wondered how it could be used to propel boats, and developed the first commercial steamboat. Nobody had done what Fulton had with that rather local, specific knowledge. He was the first to apply it to the altogether different problem of powering boats”. Boy, was Service Sam stumped.

A backbencher decided to bring the discussion closer home. “The essence of case writing”, he said, is all about ‘cutting and pasting.’ A case writer, “cuts and pastes” information from different sources”. Boka, an ardent case writer, rose in defense. “If the data and information are skillfully regrouped, such rewriting can lead to something very original. Indeed, leave alone violating copyrights, it can create new intellectual property. Consider an article in a well-known magazine consisting of 20 sentences. These sentences can be rearranged in 20! Or 2432,902,008,176,640,000 ways without changing one word of the article! Not all of these rearrangements will make sense. But if someone can do the rearranging intelligently, it can lead to a new article that will look and feel far different from the original piece and convey a very different message. And imagine the endless possibilities that exist if we combine different articles and books!” Debbie added. “Cut-paste can be a creative tool for those wanting to apply ideas from one context in another. Only when we resort to blatant copying, do problems arise. But let us not blame the technique. Let us blame the users”. The class screamed, “Long live cut-paste. Long live Microsoft”.

It was then that someone delivered the knock out punch. That, Abraham Lincoln’s famous “for the people, of the people, by the people” definition of democracy had its source in a different context in the Bible! As the gong went, Sam walked out a puzzled man. Hey, where had he gone wrong?

The Public Issue

2008-08-25T04:30:00.001-07:00

It was another tough day for Wafers. All this late sitting, which was now becoming a part of her life, was beginning to take its toll. It wasn’t easy auditing till 3 am and then turning up for classes at 6 am. The week’s class on public issue had stumped her. You can’t sleep three hours and still be awake in the class to understand public issue pricing. This business of old and new shareholders foxed her. It was taking her too much time to understand.

Sipping into his third peg of coffee, China said, “you could either be an existing shareholder or you could be a new one investing in the public issue.” Wafers realized that this was what the professor had meant when in Rule 1 he talked about “old” shareholders and “new” shareholders. It suddenly dawned on her that anyone investing in the public issue, including an existing shareholder would be a “new shareholder” for this purpose. “Yup, he would be “new” to the extent of the fresh investments that he makes,” said China, reading Wafers’ mind and, in the process, shocking her again.

Wafers recalled what she had learnt in capital budgeting. “Money must be used in projects that have a positive NPV”. To her it meant that one must compute the NPV of any project in which the public issue money is used. Her professor had called it Step 1. China volunteered a point. “The NPV should be split between the “old” and “new” shareholders. How much should be each one’s share is what the “issue price” is all about. As a “new” shareholder, given the issue price, you can figure out the share of gain”. Wow! Wasn’t this what the professor had called Case 1?

Sitting here at the Chennai Coffee Pub (which was rapidly becoming her second alma mater) Wafers had learnt that if a project has a positive NPV the market capitalization of the company goes up by the amount of NPV. Wisdom, Buddha style, dawned on her. Once the public issue was over, the market price of the share would undergo a change since the numerator would go up by the amount of NPV and the denominator by the number of additional shares issued. Rinku, the journalist, decided to showcase his knowledge. “This is what is called the theoretical post public issue price.” Step 2 told Wafers to no one in particular.

China supplied some numbers to clear the air. If a company has issued 10 lakhs shares and the market price of each share is Rs 60 the current market capitalization would be Rs 600 lakhs. Now if the company is raising Rs 500 lakhs through the public issue and issuing the shares at Rs 50 apiece, it would mean floating 10 lakhs shares. And finally if the NPV of the project in which this money is put is Rs 200 lakhs, the total capitalization would be Rs 600 + 500 +200 = Rs 1300 lakhs. As the number of shares outstanding is 10 +10 =20 lakhs, the theoretical post public issue price will be Rs 1300/20 viz. Rs 65 per share.

Wafers saw light in the darkness. So, the share will quote at Rs 65 in the market. This would mean that the new shareholders will gain Rs 5 per share (increased from Rs 60 to Rs 65). Wasn’t this what Step 3 was all about? That, “the difference between the theoretical market price and current market price represents the gain to the old shareholders”.

The price of Rs 65 would also mean that the “new” shareholders would gain Rs 15 per share (price Rs 65; paid Rs 50). Wasn’t this what Step 4 was about? That “the difference between the theoretical market price and issue price represents the gain to the new shareholders”.

Rinku summed it all up. “Since there are 10 lakhs old shares and there is a gain of Rs 5 per share, the old shareholders gain Rs 50 lakhs. And since there are 10 lakhs new shares and there is a gain of Rs 15 per share, the new shareholders gain Rs 150 lakhs. The gain aggregating to Rs 200 lakhs, is the value of the NPV.” Phew. 75% of the total gain (150/200) had gone to the new shareholders. Wafers had understood it all. Step 1, compute NPV. Step 2, compute theoretical post issue price. Step 3 and Step 4, compute gain to “old” shareholders and “new” shareholders. Wow, it had all fallen in place.

Recognizing that Wafers was quick on the uptake China decided to take the discussion to the next level. How is the price to be fixed? “In fixing the issue price, the ‘old’ shareholders will have to decide how much share of the NPV they would like to take and how much would they like to hand over to the ‘new’ shareholders.” The process would then simply have to be inverted. Wafers asked herself, “Wasn’t this what the professor had called Case 2?”

Rinku suggested that they revert to China’s numerical example to get a hang of the process. Wafers agreed. Nothing appealed to her more than numbers. Suppose the old shareholders wanted a 50% share of the NPV. This would mean that they would take Rs 100 lakhs (50% of 200 lakhs). “Hah, that was the professor’s Step 1. Compute the value of gain for old shareholders.”

China narrated, “Since there are 10 lakhs old shares, the value of NPV per share would be Rs 10. Hence the theoretical post public issue price should be current market price per gain per share viz Rs 60 plus 10 = Rs 70”. Wafers recalled Step 2. “Theoretical post public issue price equals current market price plus the old shareholder’s share of gain.”

It then struck Wafers that it was now possible to find the number of shares to be issued. Mark it, total market capitalization post public issue was known viz Rs 1300 lakhs. So was the theoretical post public issue price viz Rs 70. The number of shares would then be one divided by the other. In this case 18,57,143. Since the old shareholders held 10 lakhs shares, the number of shares to be issued was 857,143. Since Rs 500 lakhs was being raised, the price per share would be Rs 500 lakhs/857143 namely Rs 58.33 per share.

The night was closing out and it was the wee hours of the morning. Wafers told herself that it was a night well spent. She now knew a few things about public issues. “Would it not be a good idea to run classes in the night”, she asked aloud!

Killer technology in a new market

2008-08-25T04:28:00.000-07:00

Service Sam was teaching a new course titled “Managing Innovation.” There was rapt attention as everyone realized that in the outside world it was innovation that segregated the men from the boys. But as was his wont Sam wasn’t discussing banal inanities. He was now pushing the class into the insights of the celebrated innovation guru and HBS professor, Clayton Christensen. “Any guess on Christensen’s path breaking book?” asked Sam, certain that despite their high IQ none in the class would have read it.

Well, he couldn’t have been more wrong. The resident quizzer asked, “Would it be ‘The Innovator’s Dilemma’?” Flowers put up his hand. “That book talks about two kinds of technologies: one, sustaining technology and two, disruptive technology”. Boka joined the discussion. “Sir, sustaining technologies improve the performance of established products, in line with what the principal customers in major markets want. The lollypop faced Debbie remarked, “Then there are disruptive technologies which dramatically change the rules of the game bringing to the table a very different value proposition. New customer segments love such technologies”. Goggles closed out, “Products based on disruptive technology are typically cheaper, simpler, smaller and more convenient to use.” Wow. Sam was impressed.

Since the discussion had been rather technical thus far Sam decided to offer some examples of disruptive innovation. He believed that examples drove home the concepts better. And there were examples galore. Small motorcycles introduced in North America and Europe by Honda, Kawasaki and Yamaha had disrupted gas-guzzlers like BMW creating a new class of users. Transistors had disrupted vacuum tubes. The Walkman had virtually killed large stereo systems. PCs had knocked the bottom out of mainframes. The business model of health maintenance organizations had disrupted that of conventional health insurers. Internet appliances like the Blackberry were slowly overthrowing personal computers. Sam said, “In each case the new product offered an inferior performance, relative to the existing product, but was cheaper, more convenient and user friendly”.

The girl in the middle row (GITMR) spoke, “this perhaps has to do with unbundling the features and offering only what is relevant.” Sam agreed. “Often customers do not want more than what they can use. At least, they will not pay for the extra features”. Flowers whispered, “The MS Office suite has several features 50% of which customers rarely use.” Sam continued, “Market leaders improve technologies faster than what the market can absorb, so as to provide superior products that would help earn higher margins. And this is where disruptive technologies get in”. Debbie remarked, “These products begin by under-performing but over time catch up. Take PCs. When they arrived, they were slow. They did not even have a hard disc. Today, PCs can perform many complicated processing operations”. She could not have been more right.

Sam brought the discussion back to sustaining technologies. “On the other hand, products whose features match market needs today overshoot market needs tomorrow. Many customers who once needed mainframe computers for their data processing requirements no longer need them. These customers can meet most of their needs with the help of desktops that are linked to file servers. In other words, the processing needs of many computer users have increased more slowly than the rate at which computer vendors have improved their designs!” Flowers remarked, “It doesn’t matter a jot whether the speed of my computer processing is doubled if all that I do with it is Word, Excel and power-point.” He was bang on target.

Flowers chipped in. “In their attempts to stay ahead of their rivals, by developing superior products, many companies rapidly move up-market, over-satisfying the needs of their original customers. In doing so, they create a vacuum at lower price points. It is into this vacuum that the disruptive innovators enter”.

Sam added: “The innovator’s dilemma surfaces because established companies are not comfortable about investing in disruptive technologies. Disruptive products look inferior; offer lower margins and at least initially target emerging markets. The most profitable customers of the current market leaders generally don't want the disruptive technologies. The market leaders are used to listening to their best customers and identifying new products that promise more profits and more growth. They are therefore rarely able to build a business case for investing in disruptive technologies until it is too late.

This is in a way linked to the way established companies take decision. They believe in sound market research and good planning, followed by planned execution. Such companies get paralyzed when faced with disruptive technologies, which are characterized by great uncertainty and lack of market data. The current market leaders demand market data when none exists and make judgments based on financial projections when neither revenues nor costs can be known with reasonable accuracy. Market leaders also have a cost structure tailored to compete in high-end markets. Their business model makes it difficult to operate in low-end markets.”

Sam asked the class: “How do you think the market leaders should deal with this mindset problem?”

Boka responded: “Successful companies are used to a certain way of working. It will be difficult to change that mindset. So it makes sense to create an independent profit center with a cost structure tailored to achieve profits at the low margins characteristic of most disruptive technologies. The new unit must be shielded from the bureaucracy of the parent organization. This is the only viable way for established firms to harness this principle. This is exactly how IBM developed the personal computer.”

Flowers added: “I think talking to the most valuable customers does not help beyond a point. These customers want new features that make the product too complicated for most other customers. Instead, companies must try to understand what the average customer is looking for and make an inexpensive, no frills product that can meet this requirement. Then the chances of success are greater.”

Sam summed up: “All this talk about customer relationship management (CRM) needs to be taken with a pinch of salt. CRM is focused on the needs of the existing markets. It is essentially pampering the largest and most lucrative customers. It is precisely because market leaders are good at listening to customers and incorporating their suggestions that they become vulnerable to attack by disruptive innovators who go beyond the existing customers and try to identify new segments”. That’s precisely what Drucker had meant when the had said, “looking at the needs of people who are not consumers today is as important as looking at the needs of those who are.”

Knowing Doing Gap

2008-08-25T04:25:00.000-07:00

It was Friday night. And so it was hungamma time. The gang was at the Chennai Coffee pub chatting. Wafers, the young CA intern looked chic despite a hard day at office. The scribe, Rinku, was wearing his trademark dirty jeans and said he was working on a breaking story. China had told his hostel warden at IIT that he would have a night out.

Wafers was upset. The Big Boss hadn’t sacked an executive despite knowing that he was hopelessly inefficient. China wasn’t surprised. “Today, the trouble is not lack of knowledge. The trouble is not about ‘not knowing’. It is about ‘not doing’ inspite of knowing,” he said recalling the book that two Stanford professors Jeffrey Pfeiffer and Robert Sutton had written. The duo had called this phenomenon the knowing-doing gap.

“Isn’t it the same theme that the late Sumantra Ghoshal had covered in his book, A bias for action” asked Rinku. The illustrious professor, who had gone on to become the founding dean of the International School of Business, Hyderabad, had tried to explain how executives often found it difficult to get down to purposeful action and kept postponing important initiatives.

China said, “Managers often have a fair idea of what to do when faced with a problem. They have their own rich experience plus the insights of their colleagues. They read lots of books published every year. They seek the advice of management consultants armed with the latest tools and listen to gurus who constantly lecture on new concepts. But often, even with all that knowledge, nothing happens. There is little action”.
Rinku remarked, “The knowing-doing gap can be traced to a basic human propensity: the willingness to let talk substitute for action”. He recalled how his editor had once famously named such people as being members of NATO. Not the North Atlantic Treaty Organization; but No Action, Talk Only.” In Rinku’s office if someone stepped out of line, you just had to say, “Hey, NATO.”

Wafers remembered what she had read in Class X. And was sure that it had relevance here. The famous poet T S Eliot had in his outstanding poem, "The Hollow Men," written about human inertia. "Between the conception and the creation, falls the shadow," he had mentioned. China pointed out that in business that shadow was composed of words. “When dealing with a problem, people act as if discussing it and preparing plans for action are the same as actually fixing it.” Wafers agreed. Smart talk, as opposed to action, was prevalent in most of the companies that she audited.

The floor captain decided to chip in. He pointed out that management education was quite different from other kinds of training. Soldiers, pilots and surgeons all received classroom training, but it quickly turned into learning by doing. The military required soldiers to perform the very maneuvers that would be necessary during wartime. Pilots got into the cockpit and flew. In surgery, there was an old saying that described how residents learnt a procedure: "Hear one, see one, do one." In business education, the saying appeared to be, "Hear one, talk about one, talk about one some more."
The captain added: “You may not like what I say. But the fact is that most B school graduates remain talkers rather than doers, even after joining their employer”. All eyes turned towards Rinku. He had graduated from one of India’s pristine B-schools. The captain continued. "The daily life of an executive revolves around meetings, teams, and consensus building. So the more a person talks, the more valuable he appears. People who talk confidently and freely are likely to be judged by others as influential and important. So they are more likely to be hired, promoted and assigned to coveted jobs.”
Wafers thought, “This guy must have tanked his CAT exam. Sour grapes.” But Rinku had seen the point. So had China. China said, “It is hard enough to explain how to put a complex idea into practice when we understand the idea. It is impossible when we don't”. Rinku added, “Many managers do not know what they are talking about. When they are asked to define fancy terms such as "learning organization," "BPR" and "paradigm shift," they are unable to offer any definition. If at all, they give one, it is pretty vague.”
Wafers wasn’t willing to toe the lien in full. She realized that she had audited some outstanding companies that had effectively tackled the knowing-doing gap. Such companies were usually led by people who had an intimate knowledge of the organization’s people, products and processes. These leaders had come up the hierarchy. They had made it a priority to learn from lower level employees, interact with customers and be involved in day-to-day operations. Working on the front line kept them in touch with the organization's real capabilities and challenges. That experience allowed them to turn knowledge into action.
In companies that avoided the knowing-doing gap executives focused on a few straightforward priorities that had clear implications for action. Leaders in these organizations preferred plain language and simple concepts. They valued common sense. China said, “Plain talk and simple concepts are valuable because they are more likely to lead to action. You can disagree with a simple plan, but you can’t claim confusion as an excuse to ignore it.”
Wafers recalled what a CFO had once told her, “In a disabled company, criticism rules the roost. Few people are willing to offer ideas, leave alone get into action mode. I feel companies must insist that when people raise objections to new ideas or initiatives, they must also suggest how it would be possible to surmount the obstacles they foresee. In other words, conversations must be constructive and promote positive thinking. They must focus not on faults but on overcoming them.”
Rinku, the sole voice with corporate experience, said: “The best companies do not necessarily have any new strategy or any brilliant ideas. They are simply good at implementation. Great companies believe that experience is the best teacher. They convert the process of doing into an opportunity to learn. Sometimes they even start a project before they are completely sure it will work, just to learn from the experience. They launch new initiatives without waiting for every last detail to be ironed out.”
Wafers told herself that she would love to work in such outstanding companies and would one day become an outstanding leader herself.

A question of Ethics

2008-08-25T04:24:00.000-07:00

Boy, it was the final semester. And the subject: Business Ethics. What an irony. In the coming months these boys and girls would get into the big, bad, world of business and ethics would be the first casualty. Yet, they were discussing ethics in the conduct of business affairs! Professor Chatshow was saying, “In the long run, only companies which are ethical will survive. Those who take shortcuts will fall by the wayside.” Phew.

Debbie, the baby faced topper, said, “It is expensive to do business if one is ethical”. Someone asked “How?” Rising to her full height of 5ft nothing Debbie said, “Let us say a company has a hot investment proposal. If it pays speed money, the proposal gets cleared fast. Otherwise, it could take years. The message is simple: If the company is prepared to play ball, it gains. If it holds the high moral ground, it loses”. Boka stepped in. “In fact, by not paying speed money, the company is not even acting in the interests of shareholders”! What a distinct touché. Flowers brought in the global perspective. “Many companies bribed their way into Indonesia during Suharto’s tenure and are richer for the effort. Those who did not, missed out on the opportunity.”

Chatshow felt sad. Here were high voltage young graduates who would be leaders of tomorrow’s India. And they were justifying corruption. He felt duty bound to put them on the right track. And so he countered: “You cannot mechanically apply cost benefit analysis to ethics. Companies should not bother about whether the costs will be recovered immediately. They must take a long-term view.” Goggles sniped, “Sir, according to Keynes, in the long run all men are dead.” The class roared.

Chatshow swished his mane and waved them to silence. “That isn’t right,” he said. And reminded them of the English adage, ‘The king is dead, long live the king’. “Over time, companies that use sharp (euphemism for unethical) business practices collapse.” The girl in the middle row (GITMR) put her hand up. “I agree with professor,” she said. And added, “Take Enron or Tyco. Once highflying companies, the moment their misdeeds were exposed, these powerhouses crumbled like a pack of cards”. Chatshow continued, “On the other hand, ethical and transparent companies like the Tatas may suffer temporary setbacks but in the long haul they emerge stronger. In fact, the markets attach a premium to such companies.”

Flowers decided to narrate the outcome of a national survey done some years ago by a leading marketing agency. The questionnaire had only two questions. “What car did you buy?” And, “Why did you buy that car?” Those who chose Mercedes said that it was the ultimate in luxury. Those who picked Maruti said it was eminently affordable. In the case of Indica eight out of ten had written, “Because it was manufactured by the Tatas.” Mark it, they hadn’t said, “because it was an Indian car.” Imagine the pride that Ratan Tata would have felt, he pointed out. A backbencher hissed, “I guess it was worth a lifetime’s effort”.

The class sighed. Goggles wasn’t impressed. He said, “Where does one draw the line? You cannot be a Raja Harishchandra or a Mahatma Gandhi in today’s competitive environment. If somebody slaps me you cant expect me to turn the other cheek towards him, vintage Gandhi. Similarly a key skill today is to know when to speak out and when to keep shut”. Flowers supplemented. “Companies must attract customers. Take beauty care products. Women seeing such ads might think that by applying the lotion, they will become beautiful. That, their very personality will change! We know that such claims are highly exaggerated. Yet, some of the most respected FMCG companies continue to show such ads”. And then asked rhetorically, “Are they being ethical?”

GITMR decided to go hammer and tongs. “Many ads project questionable lifestyles. Like spending heavily, wearing obscene clothes etc. Then there are serials which are a bad influence on viewers. Many of them show extra marital affairs, hardly appropriate in a society like ours where the institution of marriage is sacred. Yet leading companies continue to sponsor such programs”. And then asked poignantly, “Are they being unethical?”

Chatshow realized he was losing out. Boka drove a nail. “I agree with my friends. But I want to raise a more fundamental issue.” The class waited to hear the guy with a reputation for incisive analysis. Boka didn’t let them down. “Last week I read about a US company which was trying to export its products to Brazil. The Brazilian customs officer was refusing to clear the consignment. The US Company’s local rep messaged HQ for money saying that with that payment the consignment would be cleared immediately. But the parent company would have nothing of it.

As time passed, the US Company decided to employ a high profile lawyer and paid him $50,000 as professional fees to sort out the matter. Two years later the lawyer won the case. But the question remained. Which was the better option? Paying $500 to a customs officer (who finds it difficult to make his ends meet with his meager salary) or $50,000 to a high profile lawyer?” GITMR agreed. “What’s smarter? Refusing payment and losing business? Or paying up and capturing market share? Pray, which is in the interests of your shareholders?”

Flowers chipped in: “While one feels like praising the MNC for its principled stand, I think the issue isn’t that simple. No company is in business for charity. For sure, the MNC would have recovered from the customers the additional costs that it incurred. To me, it makes greater business sense to pay speed money. After all, what is the point in following ethical principles, if it ends up hurting a vast section of society.”

Chatshow continued to feel sad. He wondered whether there was a generation gap between him and his students. Was he living life in an ivory tower? A thought crossed his mind. “We tell God, if such and such things, I shall do such and such thing for you. If that’s okay, corruption is okay”. He suddenly felt ashamed. He was worried that if the class continued for another hour, he might get converted to their point of view. Mercifully, the gong went.

Chalk, talk and trapeze walk

2008-08-25T03:24:00.000-07:00

Wafers was tired to the bones. For the seventh time that day she wondered whether she had done the smart thing in taking up CA. China, her engineering friend at IIT, had no factories to attend. Muscles, her medico pal, had no hospitals to visit. Why CA alone had articleship that demanded her to do her chartered accountant's bidding, she couldn't fathom. Here she was arguing the whole day with her client. The stupid Principal Accountant had some profit figure in his mind. Obviously dictated by his boss, the invisible CFO (was it Chief Fraud Officer, she wondered) whom she had never met. Even a greenhorn like Wafers, who had grown up reading only mushy Mills and Boon, could sense that the company was sinking like the Titanic. Yet the company wanted to report fat profits. Phew.

The blessed traffic wasn't moving. "Oh God, why the hell were they honking when the signal was still red. Was this a civilized city", asked China? She was hardly listening. "Stocks are to be valued at the lower of cost price or net realizable value," she remembered from her PE 2 days. She had then asked her Senior Manager, "Sir, does that apply for finished goods only or to raw material as well" and the good gent had said, "to both, madam." Now here at Titanic (that's how she called her sinking client company) some foolish purchase manager had used the outdated EOQ model to pile inventory at a time when the world had moved into JIT. Titanic was sitting on eight months inventory and material prices had dropped like ninepins. The raw material bought at Rs 70 per kg could now be bought or sold only at Rs 50 a kg. At the audit, she wanted the raw materials to be valued at the lower realizable price (Rs 50) but the Accountant would have none of it.
Oh, when was that Accounting Standards workshop to which her firm had sponsored her? Last month? Well the date didn't matter. What mattered was what the professor from IIM who had handled the session had said about valuations. She had jotted, "if the realizable price of the raw material is less than the cost of the raw material, the raw material need not be valued at the lower realizable price if the finished goods in which the raw material was to be used could be sold at a price which was higher than the cost of production of the finished goods." Oh God, what a mouthful she had then cursed. But the smart professor pacing up and down in his trademark "trapeze walk" had chalked in some numbers on the green board. Raw material realizable price Rs 50, raw material cost price Rs 70; Raw material could still be valued at Rs 70 if the finished goods that cost Rs 110 in which the raw material was used could be sold at Rs 111. In his inimitable style he had explained the logic saying, "the raw material is bought for conversion to finished goods; it isn't purchased for trading. The loss of Rs 20 (50-70) is notional since on conversion the finished goods would be sold at a profit fully covering the Rs 70". Even she understood.

That guy in the middle row had shot his hand up with a counter. "Sir, this would mean that if the realizable price of the raw material is less than its cost, the raw material would have to be valued at the lower realizable price if the finished goods in which the raw material is used was being sold at a price less than the cost of production of the finished goods." And like the professor he had supplied the numbers. "Raw material realizable price Rs 50, raw material cost price Rs 70; Raw material would have to be valued at Rs 50 if the finished goods that cost Rs 110 in which the raw material was used was sold at Rs 85". Wow. Must be from a big firm she had murmured. Even the professor had looked impressed and offered an explanation for nitwits like her. "While the raw material wasn't bought for trading, it would make sense to sell the raw material as it is (Rs 50) and lose Rs 20 (50-70) than to convert it into finished goods (110), sell at Rs 85 and lose Rs 25 (85-110). So you should value the raw material at Rs 50." She had seriously told herself, "So AS does take into account business sense". Why the hell could the Principal Accountant not understand she asked addressing no one in particular? May be he hadn't attended any classes.

The signal at the traffic turned green. And then it struck her. What if the numbers read differently? What if the finished goods could be sold at Rs 105 when the cost of production was Rs 110? The plain reading of the standard would suggest that the raw material would have to be valued at the lower realizable price of Rs 50 since the finished good was being sold at less than cost. But what if she extrapolated the professor's explanation? If she were running the business would she sell the raw material at Rs 50 and lose Rs 20 or would she convert it into finished goods to cost Rs 110, sell it at Rs 105 and thereby lose Rs 5. Of course she would do the latter. If that was right she should record only a loss of Rs 5 in valuing her raw material. Meaning she could value it at Rs 65 (cost price 70 less projected loss 5) instead of at Rs 50. Titanic was sitting on 10 lakh kgs of that raw material. By her argument the company could report profits higher by Rs 150 lakhs. That would be close to the target profit that the silly accountant had in mind. "Eureka", she screamed. "Yes, you can deduct the loss on finished goods (105-110) from the cost of raw material (Rs 70) to arrive at the value of the raw material …… But the value of the raw material would be restricted to the selling price of the raw material," said China. "How did you know" asked a stunned Wafers. "IIT mind" said China.

She didn't sleep that night. She raced to her office at 8 am. Her boss agreed with her analysis. The letter of the Standards doesn't matter, the spirit does, he said, patting her on her back. But for Titanic would she have ever got a hang of this? Would any textbook have explained it to her the way it struck her? Bravo articleship she told herself.

Don't be left out of the `rights' debate

2008-08-25T00:11:00.000-07:00

WAFERS looked to be in a shambles. The other morning she had bunked her CA classes. And now her friend's notebook conveyed very little on the blessed "Rights Issue". Wafers was clueless about what would constitute the best rights ratio and the best rights price. Would it be good for a company to offer more shares at a lower price? Say would a 2:1 (read two shares for every one held) ratio at Rs 25 be better than a 1:1 ratio at Rs 50? Two, it foxed her as to why stock prices changed during the rights offer.
Wafers poured her grief to China. She trusted him. Her senior at school by three years, the two had gotten along famously. He now studied at IIT, had an IQ of 160 plus, and one day hoped to work for the World Bank. The gang was at the coffee pub, generally chatting.
Oh how could she forget the pub? It was here, the previous fortnight, that the four of them had that large pasta. They had split it into four pieces and hogged like hungry dogs. The price: Rs 300 had shocked her. Cut into four, each piece had cost Rs 75. "So much dough for junk food?" she had wondered. Rinku, the journalist, always looking out for breaking stories, was half mad because he could have only one piece. The pasta had tasted great but Wafers wouldn't let him have a second; it was too pricey!
Today, Muscles, the medical intern, told the floor captain that the pasta should not be cut. He wanted to do the honours himself! Knife in hand and a napkin tied around, with the pasta on the table, he looked like the surgeon that he would one day become. He sliced the pasta into 8 pieces. "What was your problem last fortnight?" he asked Wafers. "Each piece had cost Rs 75," she said. "What does it cost now?" he asked smilingly. "Rs 37.5" Wafers responded, without battling an eyelid. "What was your problem last fortnight?" he asked Rinku. "I got only one piece," said the scribe. "How much will you get today?" Muscles hissed. "Two", said Rinku, a trifle annoyed. China, quick on the uptake, summed it up: "Last fortnight 1:1 at Rs 75. This fortnight 2:1 at Rs 37.5."
"Where had she heard it before? 1:1 at 75. 2:1 at 37.5" wondered Wafers. And then it struck her. "Oh God. The rights ratio. And the rights price." China egged her. "Are you better off today, than last fortnight?" "No", she said. Last week I paid Rs 75 for a piece that was six inches long. This week I pay Rs 37.5 for each of the two pieces, each three inches long." China turned to Rinku. "Are you better off today, than last fortnight?" "No", said the scribe. "Last week I munched a piece six inches long. This week I munch two pieces, each 3 inches long." The IITian closed out.

"Ditto for rights issue. The rights ratio and the rights price do not increase the wealth of the shareholder. Just like the pieces of cake and its price didn't make you eat more or pay more this fortnight than last." Wafers screamed, "Lesson No 1." The other diners turned around to her considerable embarrassment.
So the rights issue cannot increase the wealth of shareholders? Right? "Wrong" said China, reading Wafers' mind. "If the rights money is invested in projects with positive NPV it would increase the wealth of the company and, therefore, of the shareholders". If you add more wheat to the pasta, the size of the pasta would go up! "That's fine", said Wafers. "But how come the market price goes up immediately. After all, the NPV happens only after the event is over?"

Muscles decided to explain. "Suppose the four of us own a land whose market value is Rs 30 lakh. Now if a geologist tells us that there are 4 kg of gold underneath, what would happen?" Wafers said, "The value of the land would shoot up." The doc asked, "By how much?"

The CA intern replied, "If a kilo of gold costs Rs 5 lakh, then by Rs 5 lakh x 4 = 20 lakh. Muscles continued with his Q&A mode of narrative. "So, the value of the land would jump to Rs 50 lakh. But when would it happen?"

If there was one thing Wafers hated more than taxation it was Muscles pontificating on finance. It almost always got her goat. "Of course, immediately, silly", she said. China jutted in smiling.

He loved to see Wafers on the edge. "Provided the public believes in that information." Oh, how could she have missed that wondered Wafers.

Rinku, yelled. "Hey, one correction. It may not go up by Rs 20 lakh. After all it might take a year to dig the gold. So the land value would go up by the present value of the Rs 20 lakh."

Wow! Wafers got into the groove. "Sorry, another correction. There is the money to be spent in extracting gold. So the value of the land will not go up by the present value of the gold but by the net present value. And it happens immediately." She had hit the nail on the head.

The moral: if a project has a positive NPV and investors believe in it, the market capitalisation of the company goes up by the amount of positive NPV. The stock market discounts information ahead of time and so ups the price as soon as it receives information. "Lesson No 2", said Wafers.

Rinku decided to play spoilsport. "What happens if at the year end instead of gold we find coal underneath the land?" China turned his eye towards Wafers. She didn't disappoint him. "Well, simple. That day the price will crash".

The journalist wished to have the last word. "What if we found water?" Wafers wouldn't allow him the pleasure. "Well, water is as precious as gold these days". Even Muscles couldn't help laughing.

As they finished sipping their coffee and began to check out of the restaurant, the floor captain remarked, "Hey folks, don't start digging the ground. Even if you find gold underneath, under Indian laws, you will have to hand it over to the government!" What a distinct touché. Bravo, captain. Bravo

Look for signals on hazardous highways

2008-08-25T00:09:00.000-07:00

SERVICE Sam was teaching "markets". "Information drives the market," he said swishing his mane. "Sam, but this presupposes that there is a free flow of information to which everyone has equal access." It was Debbie, putting words into her professor's mouth. "True," said Sam appreciatively. And added, "In some situations, information stays private, that is, it is available to very few persons and is too costly for others to obtain." The class sensed that they were on to something new. A backbencher remarked, "Sam, this would put some people at an advantage compared with others."

Sam continued: "Yes. Private information affects transactions. Take driving, for instance. We know much more than the auto insurance company does about how carefully we drive". The girl in the middle row (GITMR) snipped, "We know a lot more about the condition of our car than the prospective buyer does". Goggles who had just broken up with his girlfriend whispered, "We know how much better we are than our friend does".

Boka wasn't impressed. He asked, "Sam, is life not about someone having more information than the other? Private information, in your lingo. Like, Albert Einstein had more information about science than you and I. That's how he discovered the theory of relativity. Then why make this hungamma"? The professor dismissed Boka's analysis as too simplistic and went on to explain how private information created two problems, namely, moral hazard and adverse selection: "Moral hazard exists when a party to an agreement has an incentive, after the agreement is made, to act in a manner that brings additional benefits to himself at the expense of the other party." Phew, jargon.

It was Flowers, who fought for grades with Boka, who first got off the mark. "So, when I drive a car and have taken insurance cover, I drive more recklessly than when the cover has expired. Sam would that be moral hazard?" he asked. "Absolutely," said the professor smiling. Sam loved students who gave down-to-earth examples.

The professor then moved on to explaining adverse selection as the tendency for people to enter into agreements in which they could use their private information to their personal advantage. "Suppose, I buy a second-hand car that turns out to be worthless. I would have been better off buying a used car with no defects. But the used car market does not have two prices - a low price for defective cars and a high price for good cars. Why"?

Sam then ran some numbers. "Suppose a defective used car costs Rs 15,000 and a good used car costs Rs 75,000. Whether the car is defective or not is private information available only to the current owner. Buyers can't tell the difference until they have bought the car and used it. So buyers want to pay only the price of a bad car. Just as buyers are unwilling to pay Rs 75,000 for a used car, the owners of good cars will not be willing to sell, if they do not get Rs 75,000. Hence only the owners of worthless cars are willing to sell, provided the price is above Rs 15,000!"

"But if only the owners of defective cars are selling, it means that all used cars in the market are defective cars! Thus the market for used cars will be a market for defective cars and the price will be Rs 15,000." Sam paused.
Boka put up his hand. "Sam, would that mean that moral hazard exists in the car market because sellers have an incentive to claim bad cars as good cars?
Would it also mean that adverse selection results in only the defective cars being traded?" "True," said Sam. "Here, the market isn't working well. Good used cars are not getting sold, but people want to buy such cars". He then asked, "How can the market be improved?"
Flowers responded: "We can introduce warranties. Ha. Dealers can tell a good car from a bad one since they might have regularly serviced it. They can convince buyers to pay Rs 75,000 by giving them a warranty - undertaking to bear the cost of repairing the car if it turns out to be defective, for instance".
Boka sided Flowers. "Cars with a warranty are good. Cars without a warranty are bad". The class smiled.
Debbie who loved finance interrupted, "This warranty business can be called the signal effect". Only the other day they had been taught about rights issue. "Buyers will believe the signal, because the cost of sending a false signal is high. A dealer who warranties a bad car ends up paying the high cost of repairs and also risks picking a bad reputation. So warranties enable the used car market to function with two prices, one for defective cars and another for good cars. Cars without warranty will fetch a lower price and those with warranty a higher price."

Goggles hated cars. And so asked, "Would this be true for loans?" GITMR said, "Yes, it does. The demand for loans depends on the interest rate. The lower the interest rate, the higher is the quantity of loan demanded. The supply of loan depends on the cost of lending. This cost has two parts. One, the interest rate at which banks borrow. And, two, the risk involved in lending, which varies from borrower to borrower.

"Say there are two types of borrowers: low-risk and high-risk. The former seldom default, the latter often do. Banks would like to charge a higher rate in the case of high-risk borrowers. But banks cannot identify them. Hence they must charge a uniform rate. If they offer loans to everyone at the low rate, they would attract a lot of high-risk borrowers, many of who will default leading to huge losses. If they offer loans to everyone at the high rate, most low-risk borrowers, the ideal customers for any bank, would be unwilling to borrow."

"Faced with moral hazard and adverse selection, banks use signals to discriminate between borrowers. These include length of time in a job, ownership of a home, marital status, and so on. Banks also limit loans to amounts below those demanded. Further they insist on margin money."

The class clapped. Even Service Sam couldn't have put it better.

Boka pitched in. "Auto insurance companies too look for signals. The best signal customers can send is their driving record. When customers have an impeccable driving record, the insurance company will recognise them as good drivers. But bad drivers can fake their driving records. So, a better signal used in car insurance is the "no-claim" bonuses that drivers accumulate when they do not make an insurance claim." Bravo. Bravo.

The law of unintended consequences

2008-08-25T00:07:00.000-07:00

"MAN proposes, God disposes," said China sipping in his third cup of coke. Wafers scorned. She trusted no God; she believed that Religion and Vasthu were the mantras of insecure souls.

Muscles, studying to be a heart surgeon, interrupted her thoughts saying, "That's not what China means. What he means is that many of our actions have unintended consequences."

Muscles explained, "Look, things don't often happen the way we expect them to."

And he resorted to the epics to make his point. "You know," he said, "my take is that the Kurukshetra could have been avoided."

If there was one thing Wafers disliked more than Taxation, it was to have Muscles pontificate. When he did that he was unstoppable.

"In the Mahabarata, Bhishma made the younger son, Pandu, the king, instead of the older Dhritarashtra. The logic being that a blind Dhritarashtra would not be able to govern the kingdom effectively," said Muscles.

Wafers wasn't able to understand the significance.

But China cottoned on. "When Pandu died early and Dhritarashtra took over he had a one point agenda - to perpetuate his dynasty. And that deepened the animosity between the Pandavas and Kauravas , leading to the Kurukshetra", he said.

Muscles rubbed it in, "Had Dhritarashtra been anointed King to begin with, his confidence in planning the succession would have been high. Probably, he would have remained a titular head with the real powers vested with Pandu. Perhaps he would not have been unfair to the Pandavas."

China echoed Muscles, "Kurukshetra might not have happened." And this he defined as, "The law of unintended consequences".

Wafers was beginning to understand. She wondered to herself whether there was a certain analogy to this in finance, "Like, in Capital Structure. Managers often prefer equity to debt since equity is perceived to be cheaper. Debt involves mandatory principal and interest payments. With equity, there is no compulsion to pay dividends. And rarely is equity capital returned to investors. So managers take things easy with equity funds".

China read her mind to the tee. And remarked, "Yes. That's precisely why the dotcoms folded up in the early 2000s. They had access to easy venture capital funding, they never understood the importance of equity." Wafers was aghast. She cursed, "People read my mind like a book."

Of course, she kept her thoughts to herself.

China explained, "Debt is perceived to be risky, companies tend to be more careful with the debt money. And debt often brings in quite a bit of discipline and leads to better financial performance."

Muscles added, "Leveraged buyouts are based on this very same principle." Ha, the law of unintended consequences at work.

Wafers nodded. Only the other day her professor, who taught inventory control, had told the class about "just in time".

He had remarked, " While the Japanese follow JIT (just in time), Indians follow JIC (just in case)". She had smiled then. Now she understood.

Managers maintain inventory because it acts as a buffer against uncertainty. Inventory comes in handy if a supplier delays delivery.

In the JIT system, hardly any inventory is kept. The entire plant stops if something goes wrong. Hence, the risk.

But companies like Toyota, are aware of the consequences of things going wrong in a JIT system. So they ensure that suppliers always deliver on time.

On the other hand, companies like Titanic (the multi-million dollar company that Wafers audited), which hold huge inventory, quality control is slack and vendor management slips.

In short, holding inventory undermines the effectiveness of the plant. Instead of acting as a buffer, the inventory creates problems! The law of unintended consequences!

Knowing Wafers' weakness for business-oriented examples, China decided to volunteer an analogy with small-scale industries (SSI). "After independence, our political leaders decided to promote SSI. And so many areas were reserved exclusively for them and they were given special concessions. The results were disastrous. Today, most units in the SSI sector are sick. Given the scale at which they operate, few SSIs have the financial or marketing warewithal needed to survive. The healthy units have decided to go slow on growth so that they can remain within the ceilings prescribed, and continue to enjoy the SSI status." What a shame indeed.

Wafers recalled an editorial she had read in a financial daily. It read, "During the 1990s, successive Indian governments consciously lowered interest rates. The belief was that lower interest rates would boost investments. But what has happened is the opposite. Banks are unwilling to lend to industrial projects, as their risks are not covered by these low interest rates! Instead they have chosen to invest in government securities. At the same time, they have opted for consumer financing where the spreads are higher and the risks lower. The result - rise in consumption expenditure on consumer durables. Instead of boosting investment, lower interest rates have increased consumption." Ha, the law of unintended consequences thought Wafers.

China volunteered a global example. "Germany and France, have imposed restrictions in the labour market in areas like firing and minimum wages. The aim - to protect workers. The outcome - reluctance by companies to recruit workers. Companies realise that once they hire workers, it will be difficult to retrench them. In short, labour legislation has ended up hurting their interests, instead of helping the worker!"

Wafers decided to make a mental note of what these tales revealed. That actions give a certain appearance on the surface but deep down, they are different. If we overlook the deeper issues, the most logical decisions will lead to unintended consequences! Some lesson indeed.

Arbitrage, anomalies and autos

2008-08-25T00:04:00.000-07:00

GOGGLES (because he always wore goggles outside the classroom) hadn't been quite impressed by the professor's arbitrage theory discussed last week. He had dug into the Web site for answers but it had only thrown up more questions. He had made up his mind to aggressively quiz Professor Chatshow; the latter's great reputation not withstanding.

His research had led to some startling findings. Like, the US mutual fund industry offers country funds. This is money raised in the US for investment in foreign countries. Thus, if the money is to be invested in Japan it is called Japan fund. Back in 1987, the Taiwan Fund, trading on the New York Stock Exchange (NYSE), quoted at a price that was thrice its NAV. Most interestingly, the premium stayed above 100 per cent for 10 weeks, and above 50 per cent for another 30 weeks.
"Sir, isn't that stupid?" Goggles asked Chatshow. "Why would a US investor be willing to pay a dollar to buy less than 33 cents worth of assets?" Before the professor could respond, the girl in the middle row (GITMR) cracked, "Hey, forget 1987, we were in kindergarten then." The professor ignored her wisecrack and remarked, "What could the Americans have done? To gain from arbitrage, they could have directly invested in the Taiwan market instead of investing through the fund. But the law forbade US investors from doing so. That explains the discount".

"It doesn't screamed Flowers. All eyes turned towards him. While intellectual irreverence was accepted at the B-school, raising the decibel level, that too condescendingly, wasn't. "Sorry," said Flowers. "It may explain why the arbitrage is panning out but it does not explain why people are paying for an asset three times its value."

Boka rose in Flowers' defence. "Last night I browsed the Net. In 1989, when the Berlin wall fell, German stocks shot up. By January 1990, the Germany fund was quoting at a 100 per cent premium on the NYSE. This anomaly did not seem to make sense since US investors were free to invest directly in Germany." Debbie, the lollypop faced class topper, responded: "Maybe, the American investors were too scared to invest directly in the German market and, hence, their desire to go through the fund route. And they were willing to pay the extra price." There were a few appreciative nods. Boka wasn't impressed. He said, "That's right, but why pay a 100 per cent premium?"
GITMR was tired with ancient stories. "Can we have some recent examples please?" she asked. A backbencher hissed "American Depository Receipts (ADR)". An ADR is a share of a specific foreign security held in trust by US institutions. Claims to these shares trade on the NYSE. These too quote at a price different from the value of the underlying assets. But there should not be significant deviations, since arbitrage is possible.

He recounted, "On February 18, the Infosys ADR was trading at $72.8. Simultaneously, in India, it was available at Rs 2,174. Given an exchange rate of Rs 43.8 per dollar the ADR should have quoted $50 approximately to eliminate arbitrage. That's just one example. Almost every Indian ADR is quoting at a premium". Debbie said, "Perhaps that's why Indian companies are now planning to do a sponsored ADR".

Flowers explained, "In a sponsored ADR the Indian shareholder hands over his stock for converting it into ADRs and selling it in the US market. The Indian investor then pockets the price differential".

Chatshow decided it was time for him to intervene. "Two things explain the price differentials. One, official barriers prevent Americans from buying the shares trading in Mumbai. Two, American investors might attach a premium to Infosys because its returns are negatively correlated with other assets held by Americans.

"So Infosys offers valuable diversification. Indian investors, on the other hand, might place a lower value on Infosys since it confers no diversification benefit on them". Boka wondered, "But does it still justify such a huge spread?"

The question veered to why mutual funds should quote at a discount to NAV in native India. Flowers volunteered, "The gap between market price and NAV could be for many reasons. Like, the portfolio manager charges a fee for his services. So the cash flows going to the holders of the fund are different from those going to the holders of the underlying assets. Hence the discount. Even premiums could be rational if the fund manager had superior stock picking ability".
Boka wasn't impressed. He asked aloud, "Do they call for such dramatic price gaps?"
Chatshow decided to get cracking. "A point which most people do not appreciate is that arbitrageurs may not play the game because violations of the law of one price do not necessarily create risk free arbitrage opportunities. They just create good but risky bets. After taking a position, the price differential may widen, not narrow.
"Traders may get excited (or depressed) about some security and create a major mispricing. In extreme cases, this widening spread can cause arbitrageurs to go insolvent".

"One example is the celebrated hedge fund, Long-Term Capital Management (LTCM), which had several "convergence trades" in place during the summer of 1998. Most of their bets involved mispriced securities. When spreads widened in 1998, resulting in divergence rather than convergence, LTCM ran into trouble. It attempted to raise new money, but found no takers. Mark it, LTCM had to eventually close shop." The class heard the professor in silence.

Boka decided to bring the issue to desi levels. "India violates the law of one price like no one else does," he said. "Explain," shot the professor. "When you take an auto from the city railway station, you are taken for a ride. Literally. Sir, it costs 50 per cent more than what it would if you walked 200 meters from the station to pick a plying auto."

Flowers wondered aloud, "Why do we still take an auto from inside the station?" And volunteered a reason. "Because we are lazy." "Nope," said Goggles, "Because, the police ensure that no auto is seen in the vicinity! At least, that's true of a few airports. That's some law enforcement indeed."

By now others were beginning to get a whiff of the stuff. "Nothing like day-to-day examples," hissed Debbie. "The price of a cup of coffee at the airport lobby is 50 per cent lower than that in the security area," said the resident quizzer who had only the previous week flown to Delhi to successfully win the India Quiz on television. "Rs 20 in the security area, Rs 10 at the lobby. But that isn't arbitrage," said Debbie. "When you get into the security area, you cannot come out. Hence `coffee at the entrance' is different from `coffee at the security area'. You therefore have no choice." The class smiled. Only Debbie could have put it so profoundly. "You cannot play arbitrage. You cannot buy at Rs 10 from the vendor outside and sell it at Rs 12 to the vendor inside!" closed out GITMR.
Chatshow was impressed. You don't have to go to railway stations and airports to see the presence of arbitrage."Prices of vegetables in the subzee mandi shoot 50-100 per cent by the time they arrive in departmental stores in the city. Prices of fruits are 300 per cent up when they move from the farmers to the customers. Research by NABARD reveals that in 2001, a rose cultivator got only 53 per cent of the price, which the consumer paid in Calcutta," said the resident quizzer.
Chatshow was thrilled by the way the discussion had progressed. Here was the possibility of arbitrage play. Here was a bunch of young wannabe managers who had learnt why arbitrage might appear to exist but why you cannot profit from it.

Windows of price opportunity that open for brief spells

2008-08-25T00:02:00.000-07:00

A COMMODITY cannot command two different prices in two different markets," said Professor Chatshow, kick-starting a session in financial economics. "That's no great shakes," screamed a backbencher, sporting a t-shirt carrying the legend, "me Tarzan, you Jane". That kind of irreverence, both in the learning mode and in the dress code, could be seen only at this B-school. Yet that hadn't stopped it from cracking into the elite league of India's top ten.
"Explain," snapped the professor. Flowers responded. "Let's suppose a notebook costs Rs 20 at a stationery shop and Rs 25 at the nearby stationery shop. What would I do? Well, I would buy 1,000 notebooks from the first and sell 1,000 notebooks to the second and pocket Rs 5,000 in a single day". A lone voice asked, "but Flowers, would the second shop also buy at Rs 20?" Flowers responded, "let us assume so." The girl in the middle row (GITMR) did some rapid arithmetic. "Sir, at that rate, Flowers would earn Rs 1,50,000 a month or Rs 18 lakh per annum. And he would stop coming to class." Someone hissed, "that is the kind of money which even the professor doesn't make". The class roared.
"Wisecracks apart, that was a good example of what is called arbitrage," said Chatshow. And then asked, "but will Flowers really make Rs 18 lakh in one year flat?" Boka got into the act. "Nope. When Flowers drops into the shop on the third day to buy the third thousand, the shopkeeper might up the cost by Rs 1 to touch Rs 21 to see whether Flowers would still buy. Of course Flowers would, since the margin is now Rs 4 per note book." GITMR supplemented, "may be on day 4, the shop where Flowers sells would down the price by Rs 1 to Rs 23 to see what Flowers would do".
Neta (becoming a politician was his dream) stood up. "Before long the two shopkeepers, acting independently without even knowing the existence of each other, would have upped and downed their respective prices such that Flowers wouldn't have any more free killing. And once that happens Flowers would come back to the class". The class roared.
Chatshow was happy at the way the discussion was progressing. "Yes, money isn't available for jam", he said. "There is no such thing as a money machine. This is what is known as the law of one price." And then added "for prices to equalise all investors don't have to be investment savvy. All that is needed is that enough number of investors have to recognise arbitrage opportunities!"
Goggles (because outside the classroom he was always seen in goggles) wondered whether it was such a profound statement. Was it as profound as Newton's law of gravity? Or as profound as the law of demand and supply that economics so famously preaches? After all there were price mismatches. Two B-schools offered identical curriculum; yet one charged a fee thrice that of the other. But he kept his thoughts to himself.
"Sir, we find arbitrage all over the place". It was GITMR again. "Modigliani and Miller made a fortune using it to develop the Net Operating Income theory," she said. "Two companies having the same EBIT and operating in the same business risk class cannot command two different prices in the marketplace. If they do command, then the process of arbitrage will set in motion and before long the two values will become equal." The class clapped. Chatshow waved them into silence. "Good. But is arbitrage used elsewhere?" he asked.

Boka said, "I don't know what it is called but I guess this arbitrage could be a determinant of exchange rates." The class sat up. They hadn't as yet been taught International Finance. Boka narrated, "If a basket of apples costs Rs 220 in India and $5 in the US, the exchange rate has to be Rs 44 per dollar. Suppose the rate is Rs 45, you could buy a basket in India at Rs 220, sell it in the US for $5, collect Rs 225 (45 x $5) and make a pack of Rs 5 on the deal." There was silent admiration for Boka.
The professor said, "Yup. This is called the purchasing power parity theory." Flowers, who fought for grades with Boka, remarked tongue firmly in cheek, "But sir, which American would eat Indian apples?" Someone giggled. Ignoring the barb and the giggles, the professor proceeded, "The currency of the country where the price is lower will be bought and the currency of the country where the price is higher will be sold. This free flow will soon lead to equalisation of the prices of the baskets in the two countries". And then asked, "Any other examples?"
Flowers decided to speak up. "I guess forward rates need to reflect interest rate differentials". Chatshow didn't like vague statements. "Explain," he snapped. "Suppose the interest rate in India is 10 per cent and that in US is 5 per cent. Suppose you have $100,000 available for investment. Suppose the dollar rate is Rs 40 spot. Suppose this money is invested in the US. It would fetch $105,000 at the year-end. Suppose the amount is converted into rupees; the Rs 40 lakh can be invested at 10 per cent and earn Rs 44 lakh. When this money is repatriated it wouldn't be Rs 40 per dollar. Because in that case people will rush their dollars into India. Instead, the price for the dollar would be Rs 41.90 viz Rs 44 lakh/$105,000."
Chatshow was impressed. "Good" he said. "If that isn't the forward rate, investment in one currency will be more attractive than the other. So capital will flow into the attractive currency, making it appreciate. Soon, the effective returns for investors will be equalised across the two currencies". GITMR startled everybody by saying "High interest rates in one country will be offset by a depreciation in the currency of that country." Chatshow agreed that she could not be more right. And then said, "If the notebook example was a case of arbitrage over space, this one is an example of arbitrage over time."
Goggles wasn't still impressed. He wasn't sure why he had this strange misgiving about the arbitrage theory. He somehow felt it wouldn't be true in every case. And so he asked, "Prof, does it work every time? Take close-ended funds. These when listed in the stock market quote at hefty discounts. Why?"
As Chatshow got ready to answer, the gong went. He promised he would explain it in the next class. In the meantime, as was his wont, the professor suggested that the class should log on to the Net to find some answers.

B-day clues to beat the Monday blues

2008-08-24T23:58:00.000-07:00

INDIA'S head of finance, the Harvard educated Mr P. Chidambaram, is to present the Union Budget in a short while. All of India awaits it with bated breath. After all, wasn't he the man who had delivered the dream Budget of 1997? And shouldn't he be the one to chalk the course for the next decade?
The class of 120 had assembled for a special session on Budget lingo. "This national obsession about budgeting is ridiculous," said Service Sam, the legendary professor of economics. The name had stuck ever since the day, some ten years ago, when Swaminathan Iyer had handled his first class on service marketing.
"Why do you say so, Sam?" asked Debbie, the lollypop-faced class topper. The professor had insisted that he should be called by his name, reminiscing that this was how Rusi Modi, once the powerful head of Tata Steel, had wanted to be called by his workers. After all, B-school grads were notches higher than workers, Sam had famously remarked.
"Because, we must have a long-term perspective," said the professor. Flowers murmured. "Can we have some dope on these Budget terms?" For Sam, this was familiar territory. "A budget lays down the major sources of revenue for the government, the major expenditure heads and how the gap between the total revenue and total expenditure would be bridged". Phew.
As the class gulped it, Sam scribbled a few numbers on the board. "Useful Budget stat", someone remarked.

The professor eyed the class sharply. He didn't appreciate wisecracks. "Revenue items are those whose impact is immediate. A good example of revenue receipt is tax levied by the government. Other examples include interest and dividend on investments made by the government."
As Sam sipped into a glass of orange juice, Debbie, jutted in. "Revenue expenditure is expenditure that does not result in creation of assets". She had majored in accounting and, hence, spoke the language of the accountant. "Examples please", said Sam. He hated generalisations. "Revenue expenditure is expenditure for the normal running of government departments, interest payments on government borrowings, subsidies, and so on", responded Debbie.
The professor shook his head appreciatively. And then corrected her mildly. "All grants given to State governments are also treated as revenue expenditure even though some of the grants may be for creation of assets". Flowers remarked, "Salaries" would be a revenue expenditure. Debbie sighed. Any rookie student of book keeping would know that she sneered!

"Is capital expenditure the same thing that we leant in income-tax," asked Flowers. The girl in the middle row (GITMR) wondered aloud, "Would they include acquisition of assets such as land, buildings, machinery and loans granted by the Union Government as capital expenditure?" Sam was happy at the way the queries were flowing in. "Yup" he said and then asked, "What would be capital receipts?" The resident quizzer, responded. "Would it be market loans raised by the government, borrowing from the RBI through sale of treasury bills, loans from foreign bodies and recovery of past loans". Screamed a backbencher, "Yes, that would be," much to Sam's visible annoyance. "An example of capital receipt is an IMF loan and that of capital expenditure is investment in infrastructure" closed out the backbencher.

"Sam, what are these deficits?" asked a voice. The professor rose to his full height to explain. "Revenue deficit is the difference between revenue expenditure and revenue receipts. Capital deficit is the difference between capital expenditure and capital receipts". Debbie thought, this man seems to believe that economics is arithmetic. Sam continued, "Budget deficit is the difference between total revenue and total expenditure". Flowers moved in. "The fiscal deficit would be the revenue receipts and non-debt capital receipts less total expenditure". Goggles (because outside the classroom he was always seen in goggles) was feeling edgy. He made bold to say, "Sam, all this mumbo jumbo is going over my head. Could you explain with some numbers?" The professor zipped in some figures on the board.

"Suppose you earn Rs 10 lakh a year by way of salaries and dividend income. This is your revenue receipt. You would be spending money on food and clothing, your daily sustenance. This is your revenue expenditure. If revenue expenditure exceeds revenue receipt you have a revenue deficit.
"You might have given loans to your friends in the past. These may come back in the current year. These are capital receipts. If you borrow money that too is capital receipt (a k a debt receipt). You may spend money to earn future revenue receipt. Like education and investments. These are capital expenditure. To the revenue deficit add the non-debt capital receipts and deduct the capital expenditure and you have the fiscal deficit," closed out Sam. Goggles smiled.

"Why are we making such a fuss over the fiscal deficit," he asked. "Because a large deficit may force the government to either borrow heavily or print money. If it borrows, interest rates may harden and entrepreneurs may cancel their investment plans. If it prints money and if production does not increase immediately, more money will chase the same amount of goods, leading to inflation." It was Debbie. And the class clapped.
Even Sam was impressed. "Yes too much of deficit isn't good. Actually, while the government's deficit target is 6.5 per cent of GDP, the current deficit of the States and the Centre put together is 10 per cent".
Flowers asked, "Isn't the burgeoning deficit hurting growth?" GITMR said, "I think so". And added, "Every government wants to invest in roads, water supply, power, primary education and health to accelerate growth. But it doesn't have the money." Said, Boka: "The challenge before the finance minister, as he gets ready to present Budget 2005, is in finding ways of increasing desirable expenditure while reducing the overall expenditure at the same time". Sam asked, "How will the FM address the challenge?"
Debbie got into the act. "Sam, I don't like this quarrel over fiscal deficit. The size of the deficit doesn't matter. What matters is what is it that the deficit is incurred for. If it is for current consumption, that is bad. If it finances capital investment, then it is desirable." Sam was impressed.
"True," he told the class. "In India, the deficit is funding consumption, not investments".
GITMR supplied the statistics. "Interest payments constitute 35 per cent of revenue expenditure and 48 per cent of the net revenue receipts. Pensions, (which do not increase production capacity) have grown at 21 per cent per annum during the 1990s. In the Army, pension expenditure now exceeds the pay and allowances of serving officers! Government salaries continue to be a veritable white elephant.

"Subsidies are a source of major concern. By last count they absorbed 16 per cent of the net revenue of the Centre and constituted 11 per cent of the total revenue expenditure. And then there is the loss making PSU".
The class realised that the FM had a fight on hand. Sam closed out, "We must double the expenditure on education, quadruplicate the spending on healthcare and invest heavily into infrastructure. Alas these are options that don't win votes".
He invited the class to read Gurcharan Das's Indian Unbound, which amongst other things spoke of the politician's Catch 22 situation when it came to dating reforms.

Pleasure trip and break-even point

2008-08-24T23:55:00.000-07:00

WAFERS was in a spot of bother. She had bunked the week's classes and her friend's notebook hardly told her anything about step costs that the good professor had taught. There were some smart diagrams, some natty rules, some cute problems solved - her pal was gung ho about them - but to Wafers they were all Greek and Latin. She must somehow master them Wafers told herself as she sipped her coffee.

Now munching at a Chennai club, the gang was planning a reunion of old school friends. China (studying at IIT), Muscles (doing his medical internship), Wafers (battling CA), Rinku (the scribe), Boka and Flowers (both reading at a top B-school) would all be part of the fun trip. Another thirty were expected to join the sojourn, scheduled for April 5. Rinku was taking the initiative to get it organised. It was a tough job: conceptualising, e-mailing, arranging - vintage PERT and CPM that he had read back at college.

Rinku was now sharing the details with the group. Sterling Ooty would be the rendezvous. Each member would assemble at Chennai and from there they would travel to Coimbatore by train. Thereafter it would be by road to Ooty. "Shouldn't we travel by the toy train?" asked Wafers. She had been told that the train journey was a scenic beauty. "Oh no" said China. "Five hours in the train can be killing."

"Each ticket to Coimbatore would cost Rs 500, pointed Rinku. "That's Rs 1,000 per person `up and down'; a variable cost" Wafers told herself. A van would pick them up at Coimbatore. It would cost Rs 1,400 and could accommodate up to six people. "If one person travelled it would cost Rs 1400, if three went it would be Rs 1400, if six ferried it would still be Rs 1,400. But if a 7th person travelled we would have to hire a second van and the total cost would be Rs 2,800" said Rinku.

For Wafers the coin clicked. "Ha, a step cost" she screamed. The gang stared at her. "1-6 persons one van, 7-12 is two vans, 13-18 is 3 vans," she remarked. China was the first to realise that something that had been taught in the class had become clear to Wafers. "Tube light," he hissed. "The cost is moving in class intervals; hence it is a step cost. It is constant within a class interval; hence it is step fixed cost" continued Wafers, joyous at her new understanding of cost accounting.
Rinku began to reel the numbers. "In a Sterling `twin cottage' six people can stay. The cost is Rs 500 per day or Rs 2,000 for four days of stay. I know someone there; we can get a 25 per cent discount making it Rs 1,500." Another step fixed cost thought Wafers. "How do the boarding numbers stack up", asked Muscles (the Mr Puny with the hungry look). Wafers wondered why he wanted to know. "Do you ever eat anything?" she asked. "Dieting," he said mischievously.

Rinku whipped up the scribbling pad that he carried with him even when he slept. "With group discounts it would cost Rs 1,000 per person for the four days," he said. Ha, a variable cost thought Wafers. "We will have to engage a van with a seating capacity of six for sight seeing," said China. "Yes that would be Rs 1,500 per van" purred Rinku. "Let's not forget the fixed cost of Rs 7,000 to be spent on advertisements and emailing to get in touch with the old boys," pointed out Muscles.
How much should each of us chip in asked Wafers. After all, she had to ask her mom for the money. "Rs 3,200" said Rinku. China was surprised. "Hey, at that price the trip is a steal."
Muscles volunteered, "Will we break even?" They all turned to Wafers, the bean counter. Before she could gather her wits, Rinku said "23". Wafers did her math. The train ticket at Rs 1,000 per person and the boarding charges at Rs 1,200 per person meant that the variable cost was Rs 2,200. With collection being Rs 3,200 per person, the contribution was Rs 1,000 per head. At 23 heads it added up to Rs 23,000.

She then culled out the step fixed costs. The van cost (accommodating six) was Rs 1,500, the stay (accommodating six) was Rs 1,500 and the sight seeing (accommodating six) was Rs 1,000, all adding up to Rs 4,000 per six persons. Twenty-three people would mean a block of four. So the step cost would be Rs 4,000 x 4 = Rs 16,000. Add to that the fixed cost of Rs 7,000 and you had a total cost of Rs 23,000. "Rinku is right," screamed Wafers.

Muscles asked, "What if we get 26 people?" "Of course we would make profits," said Wafers recalling her precious knowledge of break-even point (BEP). "Beyond the BEP you make only profits and profits," she remarked. "Of course not" said China. Wafers scribbled on the tissue paper. Twenty-six people meant a contribution of Rs 26,000. It also meant five vans and five cottages. So, the step cost would be Rs 20,000. The fixed cost was Rs 7,000; so, total Rs 27,000. And loss, Rs 1,000. As usual, China was right.

He smiled at her and remarked, "Try 28 people". Contribution, Rs 28,000; step cost, Rs 20,000; fixed costs, Rs 7,000; profits, Rs 1,000. Wafers blinked. "What does this mean?" she asked looking heavenwards, too proud to look into China's eyes. China said, "It means that there is a second breakeven point." Rinku chipped in "And may be a third as well." Ha, multiple BEPs. Was her class notes becoming clearer?

"How do I find the BEPs?" she asked. And suddenly remembered Step 1 from the notes, "Compute tentative BEP for each class interval." She did that by considering the step fixed cost as another fixed cost. The BEP for the first class interval of six students turned out to be 11. Wasn't that funny?

And suddenly she remembered Step 2; "Check the validity of the computed BEP." Her friend's notes screaming Step 2(a) stared at her face. "A tentative BEP is valid only if it falls within the class interval for which it is computed." In her Sterling example the numbers were 23, 27 and 31.

But what was she to make of the BEP that fell to the right of the computed class interval. "That's a loss zone," said China surprising her. She recalled Step 2(b), "If the tentative BEP falls to the right of the class interval for which it is computed, the class interval represents a loss." Meaning every number in that class interval would be a loss.

In her Sterling example, the first three class intervals were loss zones. And when would she make profits and profits, she thought. "Well if you landed up with the first full profit zone," said China, stunning her.

In her professor's lingo it was Step 2(c). "If the tentative BEP falls to the left of the class interval for which it is computed, the class interval represented by it is in the full loss zone." For her gang, beyond a group of 31 it was profits and profits.

Ha some practical use for step cost Wafers told herself.

Interest discussions needn't be boring

2008-08-24T22:58:00.000-07:00

CHATSHOW eyed the 120-odd students in his class. They were an extremely talented lot. Someone from this group would one day become India's finance minister, he thought. And one of them would surely go on to become the RBI governor he told himself. With those thoughts that made his eyes a shade misty, Chatshow decided that he would explain the link between interest rates and investments. After all, future finance ministers and future RBI honchos need to understand the link to manage the economy.

Chatshow got into his famous "ask question-offer-logic" mode. He began: "What happens if lending rates fall? Well, profits improve. What happens if profits improve? Well, cash flows improve. What happens if cash flows improve? Well, the urge to expand improves." The girl in the middle row supplemented, "If lending rates fall, businessmen either expand capacity or set up new facilities. This leads to growth." Chatshow agreed. And remarked, "That is why central banks, the world over, cut interest rates to boost growth." Flowers asked, "Sir, would that apply to India?"

"Ha, there you are" said the professor, apparently impressed by the question. He flipped in his OHP sheet that showed how interest rates in India had dropped dramatically since 1991. A backbencher remarked, "Sir, despite the sharp decline in interest rates, bank lending to industrial clients hasn't perked up and investments haven't happened." With a majestic swish of his mane Chatshow said, "Yup." And asked: "Any reasons?"

"Loanable funds theory" hissed Flowers. Boka, picking the cue, said, "The interest rate is the price of capital. When more people are willing to lend (sell capital) than borrow (buy capital), interest rates should go down." The girl in the middle row (GITMR) added, "When more people are willing to borrow than lend, interest rates should go up". Flowers closed out, "Hence, interest rates should be low in countries which enjoy a capital surplus should be high in countries which suffer capital deficit." The professor nodded.

It was then that Chatshow got into his famous act; comparing Japan with India. "In Japan", he said, "Interest rates have been close to zero for many years. Avenues for heavy capital investment, such as infrastructure, have been exhausted. Hence the demand for capital is less than the supply of capital." He paused. And then added, "But India, which is weak on infrastructure is short of capital". Flowers thought, no roads, no telecom, no power and no water. Leading software companies such as Wipro are constantly complaining about the inadequate infrastructure in India's software capital, Bangalore. Chatshow delivered his knock out punch, "So logically, interest rates in India should be much higher!"

The class was beginning to scent the fact that the professor was resenting the low interest rates in India. If proof was needed, it came in immediately. Chatshow said, "No product should ever be under priced". The girl in the middle row nodded. "If you under-price a commodity, people don't realise its worth." Flowers wisecracked, "Come Easy, Go Easy;" recalling a Hadley Chase book that he had read in school. Chatshow brought the discussion back to where it should be.

"The Asian currency crisis happened because the region was privy to cheap capital. Consequently projects with low rates of return got approved. As long as the government pegged its currency to the dollar, the party continued.

"But once the peg broke, the effective cost of borrowing, that is, the currency depreciation plus the interest rate on foreign borrowings, proved to be too much of a burden for the domestic financial system." Impressed by his own flow of words, Chatshow asked "Any questions?"

Flowers volunteered. "Sir, who benefits from low interest rates? Chatshow turned around and cooed, "Any answers?" Boka remarked, "Two entities benefit from these drops. One, `large companies' and, two, `the government'. Blue chip companies have never had any problem accessing funds. Such companies are now able to do so at even lower rates. And the government, which is burdened with a huge fiscal deficit, clearly gains."

Chatshow was impressed. "Good. That is why these two parties seek reduction in interest rates. Meanwhile, the small-scale sector, a key driver of growth in any economy, has been starved of funds. Even in the past, when interest rates were higher, this sector struggled to get funds. Now, in a lower interest rate scenario, getting funds has become harder".

A backbencher remarked, "Sir, we cannot blame banks for refusing to lend in the current scenario. When interest rates are low, banks have little incentive to lend to risky projects. It makes more sense for them to put their funds in government securities and blue chip bonds and earn smaller spreads without taking any risk". He had hit pay dirt. The class roared in approval. Even Chatshow smiled.

The professor then wondered aloud, "How has the government reduced the interest rate so much?" Flowers volunteered: "The reduction has come through administrative diktats issued by the government and the Reserve Bank and not by increasing the availability of capital, in relation to the demand". Chatshow asked, "Is there a better way of reducing interest rates?"

Boka jutted in, "We need to increase the supply of money. For that we must do three things. One, we must reduce the non-performing assets in banks. To do that we need better bankruptcy laws. Disputes relating to defaults must be resolved quickly so that capital which is locked up will be released. Two, we must improve capital productivity in public sector enterprises so that resources can be freed for infrastructure investments. And three, we should cut the huge budget deficit to reduce the demand for capital." Phew.

Chatshow summed up: "Interest rates should compensate the lenders for the risk they take. We seem to think that reducing interest rates will cut costs and overnight make our companies competitive. This is wrong. Competitiveness can come only through innovation, not artificial props. In Germany and Japan exports did not crash when their currencies appreciated against the US dollar. That is because the two countries are globally more competitive than anyone else in the world in a range of industries. They make goods which no one else can make either in terms of cost or quality or both."

The gong went. And Flowers asked, "Would it mean that for success we need to become competitive courtesy innovation than through dropped interest rates." Chatshow waved, "Yup."

A law on confusion, or confusion in law

2008-08-24T22:54:00.000-07:00

WAFERS, the CA trainee, was exasperated. She had picked up the Companies Act to check the applicability of Section 314. And she was stumped to find that if A was related to B, B need not be related to A. It took her breath away. If A was married to B's sister, under the blessed Companies Act, while A was related to B, B wasn't related to A. To Wafers it didn't make sense. But it was the law. Had not her professor once famously remarked, "The law may be an ass but it is still the law." She told herself that once she qualifies as a CA she would have nothing to do with law.

That evening Wafers poured her sorrows to her IIT pal China. But China being China, wouldn't lend her his shoulders. Instead he rubbed salt on Wafers' wound by pointing out to her the sheer size of the Companies Act and of the Income-Tax Act - more than 600 sections in the former and 300-plus in the latter without counting the IAs, the IIAs, the IOs and the IIOs. "These Acts are meant to torture rather than help the citizens of India," he acidly remarked. Mentally she agreed with him but she couldn't formally have the heart to accept it. After all, he was taking a pot-shot at her profession. So she pulled out the story her professor had once narrated, explaining why tax laws in India were top heavy.

It seemed that when the Motor Vehicles Act was first promulgated it had only one section in it. It said, "every cyclist must carry a light with him." A policeman once caught a cyclist riding without a light. "Where is the light," he asked. "Sir, its inside my pocket" said the cyclist showing a torchlight. "But shouldn't it be affixed to the cycle" asked the cop. "Sir, the law does not say so," remarked the cyclist nonplussed. And so the law was amended to bring in Section 2. "Every cyclist must carry a light and the light should be affixed to the cycle." The policeman caught the cyclist a second time. This time the light was affixed to the cycle. "Why is it not burning," he asked. "Sir, the law does not say so," said the cyclist tongue firmly in cheek.

Enter Section 3. "Every cyclist must carry a light. The light must be affixed to the cycle. The light should burn. The policeman caught the cyclist riding without a light. "Where is the light?" he asked. "Sir, it is in the rear of my cycle," he said. "But what is its use there? Shouldn't it be affixed to the front of the cycle?" asked the police. "Sir, the law does not say so," sang the cyclist. And so came Section 4... .

"Well, it makes for a nice story but it is clear that India is an over legislated and under governed country", said China. Rinku, the journalist whipped up another vintage stuff from the Companies Act. Section 2(13) defines a director as "Director, includes any person occupying the position of a director by whatever name called". Well, for sure, it didn't tell much. Even Wafers smiled. Would it mean that a director can also be a person who is not occupying the position of a director by whatever name called, she wondered aloud! "So you think our laws are convoluted? So you come out with funny stories justifying it?" It was her medico friend Muscles, biting into another pasta, who was speaking. "If you want to know something about order and method, you should have been at the operation table the other day." China asked, "Well what happened?" It was then that Muscles narrated his tale.

Five people had come to the hospital. A, B, C, F and S. A had married the elderly widow B who had a grown up daughter C. With that marriage C became A's daughter. Or step daughter if you wanted to be specific. Now F, who was A's father, came visiting them, fell in love with C and promptly married her. Because C married A's father, she became A's step mother. So was she a stepdaughter or a stepmother? And because C had married F, B (C's mother) became F's mother in law. Don't forget that by marrying A, B was already F's daughter-in-law. So was she a mother-in-law or a daughter-in-law?

"Are you sufficiently confused," asked Muscles? China stepped in with his worldly-wise wisdom. "You see, Wafers, life is like that; a complex web of relations. There is no black and white; there are only shades of grey. Your customer is your supplier. Your competitor is your partner. Your friend is your enemy.

"The one whom you love is the one who causes you the most pain. People don different roles almost simultaneously. You are both a teacher and a student. You are both a boss and a colleague". Rinku added, "at the top in any office, there is space for only one person. So as you seek to climb up you tend to push people down. And yet you smile with them. That is 21st century India; wheels within wheels". Arthur Hailey would have turned in his grave, thought Muscles.

China closed out, "you should be able to hold two diametrically opposite views in the mind and yet retain sanity. If you cannot discern and work through this complex maze, Wafers, people will call you a nice lady or they would call Muscles a nice gentleman but neither of you will go far in life.

"Does that mean that the shortest distance between two points is not necessarily a straight line?" asked Wafers. "Yup. You have got a hang of it," remarked China. Muscles couldn't help smile.

It was then that Wafers recalled Boka mention about his professor Chatshow. The mercurial professor had asked the class. "A buys into B, B buys into C, C buys into D and D buys into B. Who owns which?" Wafers' nightmare came back to haunt her.

Point of indifference between buying and piracy

2008-08-24T22:49:00.000-07:00

WAFERS was in a sour mood. She had this morning been taught "Make vs Buy" and she was literally seeing stars. At times the good professor considered fixed costs; at times he coolly ignored them. Suddenly he would talk of "indifference points" giving her nightmares. She had thought that this blessed thing called indifference point which had haunted her when she studied economics in her PE 1 was a thing of the past. Now it looked like it was transcending cost accounting.

Wafers' professor had recommended a couple of foreign books. She also had to buy the new edition of a popular tax book. One of her teachers had suggested that procuring the Revision Test Papers (RTP in CA lingo) was a must. She also wanted to buy a self-help book that would pep up her sagging confidence. Then there was the ICAI's suggested answer to be got. Yes, it would all cost money. But she knew that it was an investment. Better than the Enid Blyton series and the Harry Potter stuff that she had once egged her dad to buy for her.

"How much would it all cost?" asked Rinku, the reporter. Wafers did some quick math and said "Rs 5,000." China, her friend from IIT, chipped in. "Well there is no need to buy them. We can have them photocopied". He should know. After all, he and his friends hadn't bought a single book. These foreign books on engineering cost a fortune. The guys would pick the original and have it photocopied.

Wafers wasn't amused. "Is photocopying all right? Aren't you infringing intellectual property rights?" she asked. Rinku sneered. "When you copy from one source that's plagiarism. When you copy from many sources that's research." Watching Wafers appear unconvinced China decided to tell her a story that his professor had once told the class.

In Taiwan, a book titled Economics, authored by a Prof Chung, was selling like hot cakes. Paul Samuelson, the Nobel laureate, caught hold of a copy of the book to find why it was turning out to be a best seller. And was shocked to find that the book was a faithful reproduction of his own masterpiece Economics.

So Samuelson, along with his lawyer, flew down to Taiwan for a showdown with Prof Chung. After a few pleasantries with Samuelson, the topic veered to the book. And Chung remarked, "Mr. Samuelson its all your ideas. I copied from your book, almost word for word." Samuelson responded, "Don't you know that there is something called copyright"? Chung replied, "Of course, I do." "Then why did you copy?" asked Samuelson. "Is copyright not the right to copy," asked Chung.

"Good joke," sneered Wafers. China remarked, "You bean counters lack humour. You only talk numbers." So, he decided to spell out the arithmetic. "The cost of photocopying is Re 0.40 per page. For 8,000 pages it would be Rs 3,200. Your purchase would cost you Rs 5,000. So would you photocopy or buy?" "Well", Wafers tottered. "Purely from the money angle, I guess I should photocopy". Ha, now she remembered. The professor had said, "When you do a `make vs. buy' decision, the cost of making should be compared with the cost of buying". She had scribbled that in as Rule 10.

Rinku chipped in. "I can suggest something better. I have a friend who will charge only Re 0.30 per page but will plonk himself in your house for a week to do the job". Wafers thought: Her family was paying a rent of Rs 10,000 a month. If Mr Photocopier would stay in her house for a week, the rent for the space occupied by him could be about Rs 1,500. "Ha" remarked Rinku, "the copier guy won't pay you a nickel by way of rent." She stared. He had read her mind. For the nth time Wafers told herself that she would have to attend a program on body language.

China asked, "Are you open to accepting Rinku's offer?" Wafers computed. Rinku's offer would cost Rs 8,000 x 0.3 + Rs 1,500 = Rs 3,900. It was higher than the Rs 3,200 that the shop charged. She should reject the offer, she told herself.

Then flashed enlightenment. The Rs 1,500 was irrelevant because her dad would have to pay the rent whether she photocopied or not, whether she studied her CA or not! So the relevant cost was only Rs 2,400 (8000 x 0.3). Eureka. Wasn't that her professor's Rule 10 (b). "The term cost of making means only the variable cost of making not the total cost of making". Rent was a fixed cost and was, therefore, irrelevant. She would accept Rinku's offer. Rs 2,400 was cheaper than Rs 3,200.

Suddenly she remembered what her landlord had once said, "If you add one more person to the household you will have to pay an additional rent of Rs 1,000." True, it was unfair. But the landlord had talked of water scarcity and her dad had agreed. Now this meant that the additional Rs 1,000 is identifiable with the photocopier. The Rs 1,000, she realised, was the specific fixed cost of making.

The cost of photocopying now read Rs 2,400 + Rs 1,000 = Rs 3,400. She remembered her professor. "The cost of making is the variable cost of making plus the specific fixed cost of making". Ha, Rule 10 (c) she recalled. She would have to forget Rinku's offer because that, at Rs 3,400, was costlier than the shop (Rs 3,200) China had recommended.

China prodded. Suppose you have to photocopy 12,000 pages? Wafers did her arithmetic. Then the shop would cost her 12,000 x 0.4 = Rs 4,800. Rinku's friend would cost her 12,000 x 0.3 + 1,000 = Rs 4,600. At 8,000 pages Rinku's offer was cheaper. At 12,000 pages the shop was cheaper.

Clearly there must be a meeting point. "Ha, that's what the professor had called indifference point" she exclaimed to no one in particular. Now when would that happen? She realised that based on variable cost, Rinku's friend was cheaper, but based on fixed cost the shop was better. If she chose Rinku's friend she saved Rs 1,000 but would lose 0.10 per page. Hence, at 10,000 sheets (1000/0.1) things would even out. The professor had called it Rule 11.

She remembered his words, "Up to the indifference point the option with the lower fixed cost is better; beyond the indifference point the one with the lower variable cost per unit is better".

Photocopying had turned out to be pretty instructive! Decision making was turning out to be easy.

Heera ya paani?

2008-08-24T22:48:00.000-07:00

The captain, taking the order at Table No 3, asked "regular water or mineral water?" An irritated Wafers waved him off suggesting that "ordinary" would do. Pay Rs 15 for mineral water, huh thought Wafers. "So you think the water is too pricey?" remarked China, the IITian. A shocked Wafers asked, "How did you know?" Muscles, studying to become a heart surgeon, said "Elementary, my dear Wafers. The scorn in your face told it all." Wafers decided that she must attend some seminar on body language. The CA course gave her no insights on this.

Muscles was prescribing. "You see, the water in Chennai is bad. With the Tsunami having struck, epidemics will be on the rise. It pays to drink mineral water." China, ever eager to compare the dragon (China) with the elephant (India), wondered how the Chinese would have dealt with the problem.

Wafers' mind lay elsewhere. She was thinking of the beautiful gift her dad had bought on New Year eve. "You see, my dad bought diamond earrings for my mom last week," she told the gang. "What?" screamed Muscles. "The country is agonizing over Tsunami and your dad blows money over diamonds." Wafers didn't say, "Look it's my dad's money". Instead she said, "Hey, forget Tsunami. I am fatigued by it".

China couldn't help smile. The irony was palpable. Here was the daughter waving off a captain who had suggested a Rs 15 mineral water. And there was her father buying diamond earrings worth Rs 25,000/-. He asked: "Do you think that what is more valuable should always cost more?" Wafers roared 'Of course'. China continued: "Wrong. We need water to live. We don't need diamonds to live. If the benefit of water outweighs the benefit of diamonds, why does water cost practically nothing while diamonds are terribly expensive?"

Wafers choked. "Come on", she thought, "this is crazy". And then she remembered Lionel Robbins from her Economics class. "What had he said? Ha, Economics is a science of scarcity". She told China: "Because, water is available in plenty. (Water, water everywhere.) And diamonds are not." She felt she had served an ace. "Not really", said China. Muscles joined in, "I think I have the answer". Is he going off on a medico talk thought Wafers. "A household's consumption choices are determined by two things, Income and Preferences," remarked Muscles. Wafers realized Muscles was speaking economics. "How much we consume is limited by our income. So, given an income to spend, how we divide between two goods depends on our likes and dislikes - our preferences."

"Super doctor" thought Wafers, now back on her time machine. She remembered her professor explaining preferences. "Economists use the concept of utility to describe preferences. The benefit (or satisfaction) that a person gets from the consumption of a good or service is called utility", he had said. And for elaboration had added, "Total utility is the total benefit that a person gets from the consumption of goods and services. The more you consume, the more is the total utility as each unit provides some utility," he had said.

The professor had then explained the phrase marginal utility. Wafers had thought that "marginal" meant "negligible." But the professor said: "Marginal utility is the additional utility arising out of consuming an additional unit of the commodity." Her friend had supplied an example. If the total utility of 100 units is 1000 utils and that of 101 units is 1020 utils, the marginal utility is 20 utils.

"So you are thinking about utility, marginal utility and the law of diminishing marginal utility?" asked a grinning China. Wafers was shocked. Was her face so transparent? For the second time that evening she decided that she must attend some program on body language.

"Yup", said Wafers. "I think this water-diamond paradox has to do with marginal utility. See, as we consume more and more of something, the desire for that item reduces. Marginal utility reduces with increasing consumption". Noticing Wafers sip her third cup of Coke, Muscles remarked, "I guess having gulped two cups of coke, you are not that desperate for the third. The marginal utility of the third cup is much less than that of the first." Touché.

China now got into the act. "How should a person divide his income over the two goods"? And himself supplied the answer: "The spending should maximize total utility." For Wafers it was all dejavu.

Her professor had said: "A household's "income" and the "price it faces" limit the utility that it can obtain. Based on income and price, a household consumes goods in such a way that they maximize total utility". She again remembered Lionel Robbins. "Wants are unlimited. But resources are limited. To meet those wants, people must make choices." The professor had rounded up saying "In making these choices, they try to maximize total utility." It had looked heavy stuff then. She had simply jotted it down and gulped it into her memory!

Wafers was brought back to the present by China, who asked: "How does a person divide his income between two goods?" As both Muscles and Wafers watched, China continued, "Suppose a person keeps flipping between two goods. At what point will he stop?" Muscles said, "When he feels that there will not be any change in utility when he switches from one item to another". Wafers pitched in: "And that would happen when the marginal utility for every extra rupee we spend is same for both the items". Bravo.

"I think we are about to crack this riddle," remarked China. For centuries, philosophers had been puzzled over why water, so essential to life itself, costs little, but diamonds, (useless compared to water) were expensive. "Yes," said Wafers. "We can explain this by distinguishing between total utility and marginal utility. The total utility that we get from water is enormous. But, because we consume a lot of it, the marginal utility -- the benefit we get from one more glass of water -- diminishes to a tiny value. Diamonds, on the other hand, have a small total utility relative to water, but because we buy few diamonds, they have a high marginal utility. As a result, they are priced high." She was impressed by her own analysis.

China agreed and disagreed! "The first part is OK. But why should this make the price of diamonds so high?" And with characteristic IIT flamboyance he said, "When a household maximizes its total utility, it allocates its budget in such a way that the marginal utility per rupee spent is equal for all goods". Muscles asked, "You mean the marginal utility for a good divided by the price of the good is equal for all goods?" China nodded. And added: "This is true for diamonds and water as well. Diamonds have a high price and a high marginal utility. Water has a low price and a low marginal utility. When the high marginal utility of diamonds is divided by the high price of diamonds, the result is a number that equals the low marginal utility of water divided by the low price of water. The marginal utility per rupee spent is the same for diamonds as for water."

Wafers wondered whether China had a reservoir of brains.

The Prisoners' dilemma

2008-08-24T22:40:00.000-07:00

Professor Shondeep Chatterjee was known just as Chatshow. "Chat" being short for Chatterjee and "Show" being reflective of his talk-show style of delivery. Chatshow who was teaching game theory began: "The tool that economists use to analyze strategies and outcomes taking into account the expected behavior of others and the mutual recognition of interdependence is called game theory". The girl in the middle row yawned! It was sounding like Stephen Covey. "Dependence. Independence. Interdependence".

Chatshow continued: "Game theory is intended to understand games of all types, including the games people play in business." Flowers (because he always wore a flowered shirt) felt like screaming. Even income tax provisions would have been easier to understand, he felt.

The professor realized that he was losing the class. And so he decided to engage them in one of his stories. It had never failed him in the past. "Two men, Appu and Raja, have been caught on camera robbing a house," he began. Flowers whispered: "What's new? Being caught on camera is the in-thing". Chatshow ignored the barb. "The Assistant Commissioner of Police (ACP), who is the Chief Investigating Officer, now suspects that the duo could also be responsible for a bank heist that had its trail in both Chennai and Hyderabad. What should he do?"

Flowers thought, "Give a dog a bad name and hang it". The girl in the middle row (She always sat there and so was acronymed GITMR) interrupted, "Sir, it is simple. The ACP has to just get them to confess". Someone asked, "How?" She said, "Apply third degree." The class roared. Chatshow wasn't amused. He wasn't in the mood for wisecracks.

Chatshow continued: "The ACP is an honest officer, English style. Third degree isn't his cup of tea. He places each prisoner in a separate room, so that they cannot communicate with each other. And then tries to make them confess. If both Appu and Raja confess to the larger crime (the bank robbery), each will receive a sentence of 3 years. If Appu alone confesses and Raja does not, Appu will receive a short sentence of 1 year for having helped the police solve the crime while Raja will receive a 10-year sentence. If Raja alone confesses and Appu does not, Raja will receive a short sentence of 1 year, while Appu will have to cool his heels for 10 years". And with a majestic swish of his mane, Chatshow asked, "What do you think will happen?"

Flowers: "Each prisoner has two choices. One, confess to the bank robbery. Two, deny it."

Chatshow: "Good. What are the possible outcomes?"

GITMR: There are two players, each with two strategies. So there are four possible outcomes: Neither confesses. Both confess. Raja confesses but Appu does not. Appu confesses but Raja does not.

Chatshow noticed a few boys and girls rapidly drawing a two by two matrix. He was happy that the class was getting into the thick of action.

Chatshow: What will be the punishment in each case?

Class: "If both prisoners confess, each gets a term of 3 years. If Raja confesses but Appu denies, Appu gets 10 years and Raja gets 1 year. If Appu confesses and Raja denies, Appu gets 1 year and Raja gets 10. And if both of them deny, neither can be convicted of the bank robbery charge but both will be sentenced for the house burglary. Both will get a 2-year sentence."

The last statement impressed Chatshow. That if both of them denied, neither could be convicted of the larger crime. Consciously he hadn't expressed it. But the class had spotted it. Clearly they were quick on the uptake. He continued: "The equilibrium will occur when Appu takes the best possible action given the action of Raja. And Raja takes the best possible action given the action of Appu." He gave the class a few moments to think and then asked, "How do you think Appu and Raja should act?"

A girl in the front row put her hand up. "Let's assume Raja confesses. If Appu too confesses, Appu gets 3 years. If he denies he gets 10. It therefore pays for Appu to confess. Now let's assume Raja does not confess. If Appu confesses, Appu will get only one year. If he does not confess, Appu will get two years. It still pays to confess. Clearly the best action for Appu, regardless of what Raja does is to confess". Boka looked bored.

Happy at the reasoning, Chatshow asked, "How does Raja view the problem?" "Ditto" screamed the class.

"If Appu confesses, Raja can either confess or deny. If Raja also confesses, he gets 3 years; if he doesn't, he gets 10 years. It therefore pays to confess. If Appu does not confess, Raja can either confess or deny. If Raja confesses, he gets one year. If he does not, he gets two years. It again pays to confess. Clearly the best action, independent of what Appu does is for Raja to confess". Boka continued to look bored.

Chatshow summed up. "Neither Appu nor Raja had committed the bank robbery. But both see that, regardless of what the other does, the best action is to confess. Each will get a 3-year prison term. This is the equilibrium of the game."

Flowers remarked: "That's the prisoner's dilemma. Should I deny and rely on my accomplice to deny so that we both get only 2 years? Or should I confess hoping to get just 1 year (provided my accomplice denies) but knowing that if he also confesses, we will both get 3 years? If only each knew how the other would respond. If only each trusted the other. In the absence of these, each walks a path that effectively delivers a bad outcome for both."

Chatshow decided to move forward: "Today, we are witnessing a price war between Hindustan Lever and P&G in the detergents market. The war isn't helping any of them. It isn't the best outcome for either party. What should they do?" Suddenly there was a spark in Boka's eyes. He looked like an enlightened Buddha. Still rooted to the prisoner's dilemma he asked, "Does it not mean that those who confess may not have necessarily committed the crime?" Wacky question indeed. "Satyamevajayathe" roared a backbencher, obviously in support. Chatshow ignored him and asked "Any answers?"

The sinking dollar

2008-08-24T22:39:00.001-07:00

"The dollar is dead. Long live the dollar." Only Chatshow, the mercurial professor, could have paraphrased it so chillingly while handling international finance. "What goes up has to come down." The class did not have to turn around to see who was speaking. Not just the voice but the choice of words too could only be that of Boka. Flowers (because he perennially wore a flowered shirt) realized that if Chatshow was talking about the declining fortune of the dollar, Boka was pointing out to the pounding that the dollar had, years ago, inflicted on the pound. He remembered having read somewhere that it was the legendary speculator, George Soros, who had lead the onslaught.

Chatshow continued. "The dollar has for long been the leading international currency. But over the past three years it has fallen by 35% against the euro and by 24% against the yen. This slide reflects the structural problems in the US economy namely reckless government borrowing, relentless consumer spending and a huge current-account deficit." The B-School's in-house magazine had editorially remarked that Americans were shopping as if there was no tomorrow. Flowers had made a penciled note in his copy, "Shop till they drop dead."

The girl in the middle row stood up. "Sir, globally the central banks of emerging economies are buying dollars to consciously weaken their currencies. That way they are ensuring the price competitiveness of their exports". Chatshow was glad that the lady was abreast of current developments. He made a mental note to grade her higher in the internals this time. That was when Flowers chipped in. "This huge purchase of the dollar is leading to an expansion of the domestic money supply. This is pushing stock prices and property prices upwards." Chatshow nodded appreciatively. "If the bubble bursts, as I guess it would, the dollar would race southwards," said a voice from the rear.

Chatshow wanted to take the discussion to the next level. "There are concerns that central banks of emerging markets might reduce their holdings of American Treasury bonds. For instance, China's central bank, the second-biggest holder (after Japan) of foreign-exchange reserves, has reduced its purchases of American T-bonds. Both Russia and Indonesia were reducing the share of dollars in their reserves. All this would increase the selling pressure on the dollar," he told the class swishing his mane.

"Sir, would that mean the dollar would lose its reserve currency status?" asked the girl in the middle row. "It could," said the professor. "Sir, what's a reserve currency?" asked a backbencher. "Any answers", asked the professor. "Would it be the currency in which countries like to hold their foreign exchange surplus?" asked the resident quizzer. He had this extraordinary habit of answering every question in every quiz show with a "Would it be?" "Yup", said the professor and implored the class to read a recent issue of the Economist which had made a strong case for why and how the Euro would soon replace the dollar. A hand shot up. "Yes?" asked Chatshow. "Sir, I read that issue. The piece says that there are four requirements of a reserve currency. One, the economy must be large. Two, it must have open and deep financial markets. Three, inflation levels should be low. And four, investors must have confidence in the value of the currency". The class said, "Wah. Wah." The voice continued. "At current exchange rates, the euro area's economy is not much smaller than America's. Ever since the arrival of the euro, the European financial markets have become deeper and more liquid. While the euro area has had slower real GDP growth than America, in dollar terms its economic weight has grown relative to America's over the past five years."

As the voice slowed down, the girl in the middle row got into the act. "Sir, the dollar is no longer a great store of value. Since 1960, the dollar has fallen by around two-thirds against the pound and the yen. And as far as the fourth condition namely confidence is concerned, the value of the dollar got undermined ever since the US became the world's biggest net debtor". There wasn't a need for the class to read the Economist. These two had hit the nail on the head, summarized it cleanly! Chatshow added, "If the central banks begin selling some of their estimated $2.3 trillion dollar assets, there could be a run on the dollar".

Was there a way out? Yes and No. He pointed out to America's huge current-account deficit as the villain. The only way to correct it was by a plunge in the dollar. He continued, "Past evidence indicates that a currency has to undershoot its fair value by a wide margin to reduce a country's large external deficit". The girl intervened, "Sir, some economists believe that the dollar has to fall by at least another 30%. And if that happens, the dollar's credibility will hit a nadir. And the currency would test lower levels." Flowers remarked, "Do and you are damned, don't do and you are damned!"

Dipping into history Chatshow suggested that if the dollar had survived in the past it was because of the TINA (there is no alternative) factor. But since 1999, the euro had emerged as a potential rival. Further, in 2004, the current-account deficit was 6% of GDP, almost twice as big as at its peak in the late 1980s. In the 1980s, America had been a net foreign creditor. In 2004, it had net foreign liabilities aggregating 28% of GDP. "The dollar's days are clearly numbered", thundered Chatshow. The anti America group in the classroom clapped much to the professor's annoyance.

All along, Boka had sat like Buddha. Stone silent. But sensing the growing exuberance he decided to speak up. "Sorry, I disagree with the views expressed so far", he said. The class sat up. 90 minutes into the class and the guy was expressing reservations. "I feel a currency represents a country's global competitiveness". Flowers whispered, "Paul Samuelson, speaking". Boka ignored the barb. "If the economy is competitive, the currency will continue to be credible". Flowers whispered, "Alan Greenspan."

Boka's friend decided to join the fray. "Last night we read Michael Porter's The Competitive Advantage of Nations. He says macro economic fundamentals do not tell the full story". Boka took off. "This is the age of innovation. USA is at the leading edge of innovation. This is the age of services. Name any service and the US is the global leader. The US has also shown a remarkable ability to restructure itself. Take outsourcing. US companies are getting things done in India at low costs. In Germany and France, such a possibility evokes strong negative sentiments from the public. I believe the competitiveness of the US can never be equaled by Europe. How many European companies have succeeded in software, biotech or microprocessors? Why is it that the best brains migrate to the US, not to Europe or Japan?" he asked rhetorically.

Boka's friend said, "The US can afford a budget deficit because it has excess capacity. So inflation will always be under control. And the term current account deficit is a misnomer in today's context. If Honda USA imports engines from Thailand and exports cars to Europe, it is difficult to identify which country is exporting and which is importing!"

"Hey, there isn't a snowball's chance in hell that the Euro would replace the dollar," said the girl from the middle row quite impressed by Boka and his friend. As the class burst into applause Chatshow waved them down.

Bade miyan Vs. Chote miyan

2008-08-24T22:38:00.001-07:00

The evening when Wafers saw Mukesh Ambani tell CNBC TV 18 that there were "ownership issues" between him and his brother Anil, her heart sank. Sibling rivalry wasn't her idea of fun. That it should be played out in full public glare, with unprecedented acrimony, was unfortunate. Worse still, it involved the Ambani brothers. After all hadn't one of them gone to Stanford and the other to Wharton she asked herself.

Wafers was at the coffee pub. So was China, her IIT friend, sipping his nth cup of coffee. He would gray fast she told herself. "Reliance is not just any other family owned business", China was pontificating. "It has a market capitalization of Rs 99,000 crore. It employs over 80,000 people". Rinku, the journalist, in the same faded jeans for God knows how many years, chipped in: "RIL accounts for 3% of India's GDP. And contributes 10% of India's tax revenue." Wafers had read that the company was owned by a clutch of 14 companies which in turn were owned by a complex web of 1400 investment outfits. "Didn't such elaborate parenting mean the company had something to hide?" her CA mind had suggested.

Wafers didn't like the fight one bit. Ever since her professor had told the class about how a petrol pump attendant had gone on to become the chairman of a Fortune 500 company, she had fallen in love with Dhirubhai Ambani. And here were his two sons squabbling in public. Here was the younger brother, Anil Ambani, of the "marathon run" fame lining up legal luminaries to take his brother to court. Over what he believed were questionable share transfers that had taken place after papa's death. And expressing unhappiness with the corporate governance practices in Reliance Industries and Reliance Infocomm, the two companies that brother Mukesh Ambani controlled. If media reports were true chote miyan believed that bade miyan had taken advantage of his position as Chairman of Reliance Industries to invest heavily in these businesses while starving Anil's own businesses of cash.

Even as these thoughts crossed Wafers' mind, China was on a song. "The differences had kicked off with the formal launch of Reliance Infocomm in April 2003. Mukesh had been certain that Reliance could rope in 5 million subscribers, each of whom would pay Rs 22,000 upfront to get a free connection for a three-year period. This way, he hoped to raise over Rs 10,000 crore in one go and use it to expand the telecom network. But it didn't happen that way". Wafers snorted, "Man proposes, God disposes." Winking at her, China continued, "Instead, only 1 million users signed up leading to a huge shortfall in the resources mobilized". Wafers' admiration for China grew. Here was an engineer, so knowledgeable about corporate affairs.

Rinku took over from there. "So Mukesh drew resources from RIL to finance the telecom project at attractive terms. For instance, Rs 8,100 crore had been invested as preference shares for 10 years with a dividend commitment of Rs 16 crore a year." Wafers' accounting mind did a quick math and she realized that this amounted to a return of 0.2% per annum. To her this was the other end of a "usurious rate"! Rinku, digging into his pasta continued, "RIL was given the option to convert the preference shares into equity at any given date, but the price was left open-ended".

Anil Ambani wasn't pleased with this blind date. Was that fair? Wafers remembered what her professor had said. "In India, group companies regularly give interest-free loams to finance new projects. Reliance itself had funded Reliance Petroleum (later merged with Reliance Industries) and the purchase of the majority stake in BSES (merged later into Reliance Energy which Anil Ambani controlled)". So, what was all the noise about, she wondered. And commented, "If I were Mukesh I would be peeved by Anil's stance".

China pointed out that the relationship between Mukesh and Anil had started deteriorating even while Dhirubhai was alive. The fact that the two wives didn't see eye to eye with each other didn't help matters. Anil wasn't comfortable playing second fiddle to the Mukesh. His proposal to be made co-chairman or his mother Kokilaben to be made chairperson had been shot down by Mukesh. Bade Miyan believed papa had settled the succession question before his death.

Rinku reminded that Dhirubhai had merged the mega outfits Reliance Industries and Reliance Petrochemicals to make Reliance a Fortune 500 company. It was his way of saying that he did not want his legacy to be divided. And of conveying that Reliance should not go the way of other family run business houses which had split their businesses only to the find siblings fight each other in the marketplace and destroy value.

The question turned to who was the more capable entrepreneur. China voted for Mukesh because it was he who had masterminded the RIL's mega projects. Mukesh had single-handedly set up the world's largest petroleum refinery at Jamnagar. He had also built the Rs 20,000-crore telecom empire that would "make phone calls within India cost no more than a postcard". Rinku disagreed. He believed that Anil, as the fundraiser, had played an equally crucial role. And pointed out that the Infocomm project hadn't as yet delivered financially.

Wafers felt that Anil's political ambitions too didn't help. Mixing business with politics was the perfect elixir for disaster. Historically, the Ambanis had always stayed close to whichever party was in power. Now Anil's hobnobbing with the Samajwadi Party (SP) and then picking up a Rajya Sabha membership didn't go well with Mukesh. Wafers had also read reports of Anil's personal life style. She had read about how Dhirubhai had frowned upon his marriage to filmstar Tina Munim. And about his current friendship with a few leading ladies of Bollywood that made the conservative Ambani family uncomfortable. Bade miyan was clear that chote miyan's lifestyle and half-baked political ambitions could hurt the group's business.

Even as the media speculated on a possible split it was clear that any physical change in Reliance's organizational structure would affect the entire operations of the group. Like, RIL owned stakes in gas fields that fed the power plants of Reliance Energy. So many investment bankers and legal pundits had started wondering if a split was possible at all. Wafers felt that it was a fit case for her friend Bhoka's class to discuss. She had heard a lot from him about Chatshow. Surely he would have some answers. Like, could Dhirubhai have planned the succession better? Like would the brothers ever get back to talking terms?

Equity - A twist in the tale

2008-08-24T22:36:00.000-07:00

"How would it be if you could raise money that need not be repaid?" asked Chatshow, the mercurial professor who taught corporate finance. The class sat up in high alert knowing that the man had something up his sleeve. "It wouldn't be legal," roared a backbencher. "It wouldn't be moral" floated in another voice. As the class's eyes lit up, Bhoka, the bright guy with unconventional wisdom, raised his hand. "Sir, companies have been doing that for ages. Legally, they do not have to repay equity capital". He was bang on target. His friend joined in. "There is no moral issue since the investor knows that his investment can be realized only from the stock market". Chatshow was pleased. The class had identified that equity funds need not be returned.

He moved on. "How would it be if you could borrow money free of cost?" The girl from the middle row stood up. "Sir, whenever I raise money from my dad I neither have to return it nor do I have to pay any interest on it." "Baap ka maal hai na" said someone by way of explanation. As the class roared in approval, lest the prof think that she was being flippant the girl said, "Equity is like Baap ka maal." "How?" asked Chatshow. "Sir, because companies are not compelled to pay dividends even if they make bumper profits" she said. "Microsoft", "Microsoft" came shouts from various parts of the class. Chatshow was pleased.

He was now moving towards the board. "A father may invest in a son without expectation of a quid pro quo. But why should an investor put his hard earned after tax money if the company isn't going to reward him or return the money?" The lad sporting a flowered shirt reminiscent of the fashions of the seventies (they called him Flowers) caught Chatshow's attention. Seeing the professor, Flowers said, "Because they buy shares for capital appreciation than for dividend payment".

Chatshow was mighty pleased that the class knew its marbles. Having shown them that equity need not be repaid, that it need not be rewarded and that investors were still happy dating equity, he moved to Act 2, Scene 1. Debt.

"Debt is everything that equity is not" he began. The silence in the class was palpable. They knew the professor had a way with words. "Debt has to be repaid. Worse still, it has to be serviced, come hell or high water. Then why at all do companies use debt?" "Sir, that's simple." It was the girl from the middle row standing up again. Chatshow disliked the word "Sir". He had once famously remarked, "Hey, I haven't been knighted as yet." The girl said, "Sir, debt is cheaper than equity. Because interest is tax deductible and dividends are not." Chatshow made a mental point that while she was right on the fact she was wrong on the conclusion. "Debt is cheaper even otherwise" he said. And left it at that.

Someone interjected. "Sir, what is the cost of equity?" As Chatshow turned in the direction of the voice, a backbencher roared, "the cost of equity is the rate of return which equity investors expect from the firm". The professor was thrilled. This group appeared to be well groomed in finance. "Could someone tell me how is this return computed?" As the class turned silent the professor prompted, "What is the expected return in case of equity?" "Dividends" said a lone voice. "But people don't buy shares for dividends" said Bhoka. And added, "They buy in expectation of capital appreciation. They buy when the prices are low and sell when they are high." He was sounding like Peter Lynch!

Sensing that the class was "in-the-mood" Chatshow prompted, "What kind of capital appreciation do investors expect?" "More than the interest rate," said a husky voice. "Because equity investors are taking more risk than those who invest in debt" called out another. This was great. The entire class, not just one or two students, was participating. With a broad grin on his face, Chatshow concluded: "Now do you understand why equity is more expensive? And it is because equity is more expensive that companies also use debt."

It was then that the guy in the flowered shirt sporting a disinterested look made a point: "Sir, the investor who is selling and encashing his reward is not selling to the company. He is selling in the open market. Okay, he makes profits but as far as the company is concerned he is simply passing the parcel. So why is his expected return a cost to the company?" There was pin drop silence. And stunning admiration. It was a chilling point. For a moment, the mercurial Chatshow looked flummoxed. "Any answers?" he asked. Bhoka realized that the professor wasn't asking "Any questions?" The previous night Bhoka had studied Van Horne. And Brealy and Myers. He had the same doubt. Neither of the books had clarified it.

The girl from the middle row stood up. "Sir, its like this. An investor invests in a rights issue, say, at Rs 100. He has a one-year time horizon with an expected return of 20%. He doesn't care how the return comes, whether from dividend or from capital appreciation, so long as they come. If the returns do not come he would start selling in the market taking the price southwards. Further, next time around when the company does a rights at Rs 100 he wouldn't care to invest. Hence it is in the company's interest to take the price to Rs 120/-. Hence it is cost for the company". Bhoka nodded.

The girl had got the insight from her friend Wafers, the CA trainee. Wafers' professor had given a cute example from employee compensation. He had explained, "A company is on the look out for a CFO. The candidate wants an annual cheque of Rs 50 lakhs. The company offers him Rs 25 lakhs plus equity options which in one year's time would hopefully be saleable at Rs 25 lakhs. A year later the market value is Rs 10 lakhs. The company thinks that the CFO has effectively cost it only Rs 35 lakhs. The CFO resigns and the hunt is on for his successor. He too wants Rs 50 lakhs. The company offers him what it offered his predecessor. He refuses because he knew what happened last year. So the company offers him Rs 35 lakhs plus Rs 15 lakhs of equity options. A year later the options are saleable at Rs 10 lakhs. The company thinks that the CFO has effectively cost it only Rs 45 lakhs. He resigns and a new CFO joins. He wants Rs 50 lakhs. The company offers Rs 35 lakhs cash and Rs 15 lakhs equity options. The CFO refuses because he knew what happened last year. So he asks for Rs 50 lakhs cash. The moral: before long the cost catches up with the company".

Even Chatshow smiled.

Calling the bluff

2008-08-24T22:35:00.000-07:00

Dick Bird, the iconic CEO of Getwell Inc, was facing the biggest crisis of his career. The gathering storm could completely undo every good thing that he had done in the last twenty years. One of the company's best selling products, Aarthu, used by arthritis patients, was creating serious side effects among patients. Fresh media reports were suggesting that those who consumed the drug on a long-term basis were prone to increased incidence of heart attacks and strokes.

Last winter, Getwell had celebrated its platinum jubilee. The company practiced business ethics as a credo. Customer first was its mantra. It wore social responsibility on its sleeve. Getwell had donated large sums of money to fight infectious diseases in developing countries. In surveys carried out by the media, it always figured amongst the most admired companies. In industry circles it was known for its high quality research that had led to the manufacture of innovative drugs to cure a wide range of ailments including hypertension, osteoporosis and high cholesterol. There was this rumor that it had even cracked AIDS. The company's top management was a class apart. CEO after CEO had led the company with great vision. To many an investor, Getwell was the ultimate blue chip stock.

The arthritis drug had been developed during the tenure of Rob Walters, one of the most respected R&D chiefs the company ever had. Walters, a medical doctor by training, was a stickler for perfection. He never took anything for granted and had trained his scientists to provide detailed, meticulously prepared supporting documents to regulatory authorities, whenever Getwell came up with a new drug. Consequently, Getwell's drugs were approved normally within six months, as against the two years for Getwell's closest competitors.

The arthritis drug had been discovered in Getwell's lab in 1998. During trials, it had been a big success. It received approval for open marketing in 2001. The company had spent over $500 million on ad campaigns that highlighted its benefits. Till September 2004, some 20 million patients had consumed the drug, accounting for more than 10% of the company's sales. Walters had recently retired. And the crisis erupted soon thereafter. His successor, Michael Yang, a reputed scientist from the John Hopkins College, one of the most admired medical institutions in the world, was left holding the baby.

In early November 2004, Bird and Yang were deliberating on the course of action the company should take. The company's legal chief, Mathew Martin, joined them.

Bird: How bad is the situation?

Yang: There are reports that people who have been taking the medicine for more than two years have twice the risk of heart attacks than those who do not take this medicine.

Bird: How does the legal situation look like?

Martin: We do not know how many lawsuits have been filed. But the number will be very large. We know that at least 20 million people have used the drug. I have reports that many lawyers are setting up toll free numbers to solicit potential clients among patients who have consumed the drug. If these become class action lawsuits, the company might face huge liabilities.

Bird swept the growing beads of perspiration from his head. He didn't like it one bit. As he picked up the cup to sip in his fourth cup of coffee he knew he was licked.

Yang: What is a class action suit?

Martin: A judge in a court might decide that all complaints in their jurisdiction may be considered as one petition viz one class. Once this happens, history tells us that the defendant could get into a big hole because of the large-scale publicity and heavy pressure from the public. The lawsuits can force us into bankruptcy.

Bird: We have been quite transparent. In 2002, we even updated the label and mentioned clearly that there was a higher possibility of cardiovascular risk.

Martin: Sure. We have done more than any company would. But let us not underestimate the lawyers. Millions of patients have consumed the drug and thousands have suffered heart attacks. After all, heart attacks are one of the most common causes of death. So the judges will look for casual connection. You can bet your shirt that some lawyers will find some doctors to testify in their favor.

Yang: Shit. I should have done better PR with the Director of Alpha Clinic. He had prepared a detailed analysis and wanted to meet me. I cold-shouldered him because he has always been critical of us. He has now gone on record in a national TV channel saying: "Had Getwell not valued sales over safety, a test could have been initiated at a fraction of the cost of the marketing campaign used to popularize the drug." That could be used as evidence in the court.

Bird swore under his breath. "Stupid Yang." "Why could he have not been more careful?" his subconscious self told him.

Bird: What else do we have?

Yang: A leading doctor has been quoted as saying we should have tested the drug specifically on heart patients. That would have revealed the cardiovascular risks much earlier. I had discussed this with Walters a few months before he retired, but he was not keen.

Bird: We have held the high moral ground for the past several decades. I am relinquishing office next year. And I do not want to do anything which will damage our reputation.

Martin: Are you thinking of a product recall? Please don't. It would be the surest sign that we are admitting guilt.

Yang: If only Walters had not been that overconfident, we would have done the extra test and accumulated clinching evidence in our favor.

As the meeting ended inconclusively, Bird wondered what he must do. He had talented people like Martin and Yang, whom he could consult. But the buck ultimately stopped with him.

A week later, Bird recalled the drug. The pink dailies carried banner headlines. Sharp editorials were written. The following day the company's stock price plunged on Wall Street. Hundreds of employees, Bird included, who held options in the company, saw their investment plummet. There were reports of courts being flooded with petitions.

Products are Services. Services are Products

2008-08-24T22:34:00.000-07:00

Sam taught Service Marketing in the same high profile B-School in which Chatshow taught Knowledge Management. It was his first class for the new batch of second year students. He had been into teaching for a little over 20 years and always exuded confidence. Chatshow had warned him of Bhoka (he was so good that this was the only way that students could get even with him) who challenged conventional wisdom. But Sam pooh-poohed Chatshow saying he could handle them all. Like Chatshow, Sam was a popular teacher with an engaging pedagogue. After proudly introducing himself to the class as Service Sam, he briefly outlined the course content and the grading mechanism. And then got into his interactive stride.

Sam: Do you think you will benefit from this course?

Class: (in chorus): Yes sir.

Sam: How?

Class: Sir, today's economy is a service economy. In most developed countries, services account for more than 70% of GDP. India too is heading in that direction. The best jobs are lying in services. Service is to sunrise as manufacturing is to sunset. This course is going to add a lot of value for us.

Sam was happy with the response. But he was alarmed at hearing the jargon "adding value". He was convinced that these MBA blokes used the term loosely without really understanding what it meant. So he got into his next volley of questions.

Sam: Why do we need a separate subject called Service marketing?

Class: Because services are different from products.

Sam: Pray how?

Class: Sir, a product is tangible. A service is not. A service cannot be seen. It cannot be tasted. It cannot be felt. It cannot be heard. It cannot be smelt.

Sam: Any more differences?

Class: Services are delivered and consumed instantaneously. Products are manufactured, stored as inventory, distributed through channels and consumed many days later.

Sam was impressed. These guys seemed to know their marbles. Most importantly the answers were coming from different directions of the class. This was very unlike some other classes where a bloke or two would dominate the chat. It was a joy to teach a bunch of highly motivated students.

Sam: Is that all folks?

Class: There is a high degree of variability in the case of services. Here "People" play a crucial role. This is not so true of products. The quality of a service is people centric. If a chef changes in a restaurant, I may not visit the restaurant again.

Class: A barber leaves the saloon. I will get my hair dressed in the new saloon where my favorite barber has relocated. My auditor changes his firm and I shift to the new firm. Different people deal with customers in different ways

Sam: Well anything else?

Class: Services are perishable. They cannot be stored. An empty seat on an airline flight is lost forever.

Sam was thrilled by the way the class was progressing. It looked like the guys hadn't forgotten Philip Kotler whose colourful book they had read in the first year Basic Marketing course. He complemented them on their quick response and good grasp of basic marketing concepts. Smiles were exchanged amongst students across the oval shaped classroom that had gallery type seating and which accommodated 90 students. Sam mentally heaved a sigh of relief. He seemed to have got the class on his side.

That was when the jean clad, mop haired, bespectacled Bhoka spoke up. He gave both Sam and the class a jolt.

Bhoka: Sir, can I make a point?

Sam: Sure, go ahead.

Bhoka: I don't think there is any difference between a product and a service.

Sam (a shade irritated): Can you elaborate?

Bhoka: Let me take the first point. A service can also be tangible. Take McDonald's. It is in the services business but what it makes are burgers. Burgers are as tangible as anything else.

Sam: Continue.

Bhoka: Two, like products, services can also be stored. A software is stored on a computer. Many routine responses to customer queries in the tourism industry are stored in databases. Automated responses drive customer service in several service industries including airlines and banks.

Sam: Third point?

Bhoka: I do not think people are any the less critical in the case of products. Like you need good doctors to run hospitals, you need good people to design, manufacture and market products. Surely people played a key role when Tata Motors designed the Indica? And when Sony designed the Walkman?

Sam was beginning to get the jitters. Bhoka continued: "Products can be as perishable as services. A vegetable is a product. A vegetable vendor has to sell it by the end of the day. A newspaper is a product. A newspaper boy has to sell it the same day. Laptops are products. They have to be sold within a reasonable time. If microprocessor technology changes, laptops lose value sharply. That is why a company like Dell has pioneered the build-to-order, direct selling model".

The class was getting excited. Bhoka, like Sachin Tendulkar, in full flow, was always a pleasure to watch. And here he was challenging the natty professor, in a way only he could. Well, what had he said? "Services can also be tangible". "Services can also be stored". "People are important everywhere". And "products are also perishable". Sam was looking like a wounded tiger. And feeling like a confused scientist. Bhoka seemed to have demolished all the concepts, Sam held sacred. Did this mean that there was no difference between products and services? No service economy? No knowledge economy? The gong went and Sam ran for cover. Of course the class didn't know that. Sam had a reputation. And the class believed that like a master storyteller Sam had timed it in such a way that he would offer the answers the next week. Only Sam knew that he had no answers! He had to find them. Well, he had better find them.

Who should be paid more? Medical Rep or Software programmer?

2008-08-24T22:31:00.000-07:00

Shondeep (yes that's how he spelt it) Chatterjee, taught Knowledge Management at one of India's up-market B-Schools. He wasn't your archetypal professor. Twenty years in the industry had given him an insight into how corporate India worked. Two years ago when he made the switch to academics it was the heart which ruled the head. For, teaching gave him unalloyed joy. The class generally liked the unassuming soft-spoken professor and lovingly called him Chatshow, a dab at his name.

Chatshow trusted Socrates. At the classroom he never lectured. He only asked questions and gave his views only when he found that the solution was beyond the students. He believed that most of the time, the students had the answers even if they were new to the subject. Make them "learn to learn" was his philosophy. On Nov 11, even Chatshow was unprepared for the bizarre developments that would take place in the class.

Chatshow: Hi folks. Do you think that this subject has any use for you?

Class: Of course Sir (in chorus). We live in a knowledge society. Knowledge is power.

Chatshow: If knowledge is power, what should it lead to?

Class: Better career prospects. And more money.

Chatshow: Can I say that people with knowledge will make more money than those without knowledge?

The class agreed. But Bhoka (he was so good that this was the only way that the class could get even with him) would have none of it. "Sir, two guys may be equally knowledgeable. But one may earn more than the other. I feel some forms of knowledge are more valuable. And the person with that "more valuable" knowledge gets paid more." Chatshow was impressed. None could disagree with Bhoka's logic. For Chatshow, it presented another opportunity to experiment.

Chatshow: Can you give an example of a knowledge intensive industry?

Class: Computer Software.

Chatshow: Well what are its defining characteristics?

Class: It is export oriented. It is profitable. And it employs knowledge professionals.

Chatshow: Who are the most important people in a top software company like TCS?

The class debated at length on whether it was the Marketing team or the techies who were more crucial. With some prompting from Chatshow, the class quickly agreed that an overwhelming majority of the workforce in these companies were techies. These were the young programmers who worked long hours on computers to write thousands of lines of code. True they were expendable. Meaning if one techie left, another could join in. True being entry-level staff they were paid less compared to the project managers. But their sheer numbers and their technical knowledge made them the key contributors to the organization. Indeed, senior managers in these companies spent considerable time wondering how to attract, retain and motivate these young upstarts. A top CEO had once famously remarked: "Every evening our assets (the techies) walk out of the door. We wait anxiously hoping they return the next morning."

Chatshow: Tell me another industry which is similar to the software industry in terms of its defining features

Class: Pharmaceutical industry. Pharma companies sell their products globally. They operate in a knowledge intensive industry. And by and large they are profitable.

Chatshow: Who are the real drivers in the pharma industry?

Class: The R&D staff.

Chatshow: Why?

Class: R&D is necessary to develop new drugs. Without a steady stream of new drugs, no pharma company can retain its competitive edge.

Chatshow: What kind of R&D do Indian pharma companies do?

The class slipped into silence. Then one student, who was interested in the industry said, "In India, we have process patents, not product patents. Companies examine blockbuster drugs produced by global players like Merck and Pfizer and remake them with a slightly different composition and using a slightly different process. This is called reverse engineering. Like remix, in the music industry! Chatshow was impressed.

Chatshow: Ranbaxy is strong in antibiotics. What would happen if it introduced in India a new antibiotic based on a blockbuster drug that Eli Lilly launched in the US?

Class: CIPLA or Dr. Reddy's will follow suit quickly.

Chatshow: So what is the real challenge for India's pharma companies if they make look alike drugs?

Class: Marketing. The company should be able to convince the doctors that its product is better.

Chatshow: So who drives the show in the pharma industry?

Class: The medical representatives, sir. They meet the doctors. The quality of their efforts drives sales.

Chatshow: Let us get back to what we discussed in the beginning of the class. People should be paid according to the knowledge they possess. Who possesses superior knowledge, the techies or the medical representatives?

Class: The techies.

Chatshow remarked in his usual confident, flamboyant style: "So now you know why the techies are paid much more than the reps even though both play a significant role in their companies." He thought he had made a flashy point.

As the class nodded their heads in unison, Bhoka got into the act. "Medical reps have specialized knowledge. I feel that managing relationships with doctors is more difficult than writing a computer program. You need to read the doctors' mind. You need to deal with them with caution since technically the doctor is the boss". He drove the nail saying, "It is wrong to view medical reps as people roaming around from place to place with their bags."

Chatshow asked Bhoka to explain. Bhoka continued: "If a techie gets stuck while writing a program he can sit on his bottom and consult a colleague. But the medical rep has to think on his feet. In a few seconds, he has to gauge the mood of the busy doctor and make his pitch suitably. Therefore he is taking real time decisions. The techie may be brainy, but he is doing work where the steps are clearly defined. He also gets time to correct things when they go wrong. Effectively, he takes off line decisions. And most importantly his knowledge is not easily transferable."

Chatshow wasn't willing to give up. But surely the techie has better education, right?, he remarked.

Bhoka continued "Sorry Sir. Today engineering colleges have mushroomed all over the country. Anyone can get a seat. A medical rep who has done an M Sc. from a good college is better qualified than an engineer from one of those private colleges. In fact, it is easier to get into the engineering college than into Loyola or Madras Christian!"

By now the class was beginning to see Bhoka's logic. So did it mean that medical reps deserved to be paid more than the techies? And if they are paid handsomely will some of the brightest guys take it up as a career? Chatshow asked the class to reflect on the issue. As he left the class he knew full well that he had been stumped. Bravo Bhoka.

Original. Duplicate. Previous. AS(s)

2008-08-24T22:15:00.000-07:00

Wafers wasn't too sure whether she should feel excited or appalled. Taxation made sound economic sense, but issues such as amendments, case laws and judgments stumped her. Why can't they keep the laws simple she wondered? 300 sections under the Income Tax Act, not counting the A, the AA, the BB (i) and their ilk was quite a mouthful. These helped only the tax practioners, she had once argued exasperatedly. Corporate law baffled her no end. Some of those cases in mercantile law were cute but the Companies Act was getting bulkier by the day. It looked as though these were meant to help only the lawyers. As a nation with a billion plus population, we seem to believe in "more, the merrier" she told herself.

Now here was a new trouble. The one subject which she had found to her taste, Accountancy, was threatening to go the tax way. She had admired Luca Paciolli. "Every debit must have a corresponding credit" was the inspiration for Newton's "every action has an equal and opposite reaction" her teacher had told in the opening session in class XI. And ever since she had fallen in love with Accountancy. At her CA classes her professor had remarked, "accounting jobs are going up in smoke, since technology is taking away most of the accountants' traditional role". He had added, "The relevant accounting jobs today are those that involve specialization in disclosure." It was her first brush with Accounting Standards. It hadn't dampened her spirits. He had talked about how the Institute was working overtime. Between 1979 and 1995, 15 standards had been put in place. Then between 2000 and 2004, 14 standards had sprung up. As her friend had pointed out, you needed a standard to understand the standards! More paragraphs. More illustrations. More confusion.

Titanic, the multi-million dollar company that she audited was the source of her new trouble. The company had spent a huge chunk of money in increasing the production capabilities of its plant and machinery. Five years ago, the machinery had been bought to produce 100 K units of the finished products. In the first two years, it had achieved 90 K units of production. Across the next three years, its productivity dropped and it could achieve only 70 K units per annum. The new expenditure, R & D confirmed, would increase the production to 80 K units per annum. The company wanted to capitalize the spending while Wafers trusted it was revenue in nature.

Titanic argued for capitalization saying the asset's productivity had increased. Wafers had no trouble with the logic. But she had trouble accepting the numbers. She contended that productivity had to increase beyond 100 K units to merit capitalization. She called it the installed capacity. Coming as it did from the manufacturer, Wafers felt, it was the more reliable number. Titanic held that that the benchmark was the 70 K units that it had been achieving in the past. Wafers called it "Actual production". The CAO (Chief Accounts Officer) argued that the so-called installed capacity could be biased. He told her the story of how he had bought a car that had a manufacturer specification of 18 km per litre for fuel efficiency but which actually gave him only 12 km per litre on the road. Peeved, he had sent the car back. The company had it tested and confirmed that it's 18 km per litre was correct. He had asked them "how". And the automobile company told him that it had plonked the car atop a pole, a driver sat inside accelerating the car; an engineer clocked the revolutions per second the wheel made and from that the mileage inferred! No change of gears, no traffic, all laboratory tested. The CAO's take was simple. The 100K was lab tested, the manufacturer wasn't an unbiased judge and so that number could not be taken as the base.
Even Wafers smiled. She was willing to see his point of view. But felt that the benchmark figure should atleast be the production level of 90 K achieved in the first two years. This time the CAO threw the rulebook (read AS) at her saying that AS 10 suggested that, "if the expenditure increased future benefits from the existing asset beyond its "previously" assessed level of performance, then the expenditure is to be capitalized". "Previously" would naturally mean "immediate previous" he argued. Wafers wasn't too keen on verbal gymnastics. She only had two viewpoints. One, if the CAO was right, then every piece of servicing leading to an increase in the output by a unit or two, would call for capitalization. And two that what was meant by previously assessed was only the originally assessed performance.
The CAO again threw the rulebook at her, inviting her to take a look at AS 26 on intangibles. Subsequent expenditure on an intangible asset can be capitalized only if it will enable the asset to generate future economic benefits in excess of its "originally" assessed standard of performance. Talking about review of amortization the standard further says, "useful life can be increased due to improvement over "originally" assessed standard of performance" on account of value additions. The use of the word "previously" in one standard and "originally" in another is to indicate that these carried different meanings pointed out the CAO. Stumped, Wafers argued, that one cannot interpret every word literally and that we must appreciate the spirit of the standard. The CAO smiled. "Wafers", he said, "spirit, like beauty, lies in the eye of the beholder. And that under the circumstances it made a lot of sense to interpret the letter of the law because to understand the spirit you need to go back to the guy who drafted the standard"!

Wafers was beginning to feel robbed by this endless hairsplitting. She was reminded of the natty story her tax professor had once told her. A client of his wanted to claim the fee that he paid his barber as business expenditure. When it was explained to the client that this was an expenditure of a personal nature and such expenses were not tax deductible he pointed out that since he spent 50% of his time at office 50% of the growth arose in the course of business and hence atleast 50% of the fee payable to the barber was tax deductible.

She spoke to Doc, her senior audit manager, insisting that the audit report has to be a "qualified report". Doc asked her to tell the CAO to get a legal opinion that could support the CAO's view. An accounting firm seeking a legal view on an accounting matter! What was happening wondered Wafers.

Want Return? Take risk

2008-08-24T22:13:00.000-07:00

The newspaper ad took Wafers' breath away. A young woman was willing to jump down from the 25th floor of Express Towers, provided someone was willing to pay her Rs 1 lakh for the effort. "Foolish woman" said Wafers. "Why, what's wrong with that? Is Rs 1 lakh not good enough?" asked China, sipping a mug of coke. "Or do you think she shouldn't jump from the 25th floor?" volunteered Muscles half smilingly. "I wouldn't jump even if they offered me a crore," remarked Wafers. Rinku chipped in, "What if it were Rs 5 crore?" Wafers was quiet prompting China to say, "So what we are discussing is the price, not the craziness of the effort."

For Wafers the coin clicked. The other day, her professor, explaining Return and Risk, had laid down Rule No 4, "For a given level of risk (craziness), different people look for different return (money)". Now she understood it. The lady who had given the ad would be happy with Rs 1 lakh, Wafers would be happy only with Rs 5 crore. Even as she mulled over it, China observed, tongue firmly in cheek, "I hope you realize that your heirs, not you, may have to collect the cheque." That gave Wafers a second crucial insight into risk. Here risk meant you wouldn't be able to collect the return.
But "How does one quantify risk? How does one decide which option is riskier?" she wondered. Okay jumping from the 30th floor is riskier than jumping from the 25th but not every time are the options so obvious.
Rinku was animatedly talking cricket. Silly chap, she thought. "Whom should we drop, Dravid or Laxman?" was the issue. "Fall back on stat" suggested China. Rinku reeled out the numbers from the top of his head. During the last 10 innings Dravid had scored 60, 40, 50, 50, 40, 80, 20, 70, 60 and 50 for an average of 52. In contrast, Laxman had scored 110, 10, 0, 80, 20, 120, 20, 90, 10 and 60 also for an average of 52. "Whom would you retain?" prompted China. "Obviously Dravid. He is consistent," said Rinku. "Right" said Muscles. For Wafers the coin clicked a third time. "If someone is consistent he is more reliable and hence less risky". China helped her saying, "Mathematically, one can measure consistency by computing the standard deviation of the scores". Dravid's scores were closer to the mean (52) than Laxman's. His standard deviation, and hence his risk, is lower. Muscles added, "if you plot the scores on a graph and if it resembles the graph of a heart patient's ECG it means it carries more risk!" That was cute, thought Wafers. She now understood why standard deviation measures risk.

Even as she was salivating her newfound knowledge, Wafers heard Muscles talk of what had happened that morning at the operation theatre. The anxious patient had asked the surgeon "Doc, what are the chances of my survival?" The doctor had remarked, "The success rate is generally 10%. My previous nine patients died on the operation table itself. You are the 10th patient. You are sure to survive; 100%!" Wafers recalled what she had learnt In the classroom. That when it came to risk you assigned probability. And for that you had to rely on the past. The story of the surgeon made Wafers wonder whether too much should be read into probability.

"Is it possible to reduce risk?" Rinku asked, his mind still on cricket. Wafers recalled her professor's words "Diversification reduces risk." He had quoted the proverb "Do not put all your eggs in one basket" as proof. But had nattily added Mark Twain's remark, "put all your eggs in one basket and watch the basket grow!" The message: If you want to maximize return bet on your best product; if you want to minimize risk diversify. A smart aleck in the class had asked, "Sir, is that why you studied both CA and ICWA?" And had quickly supplied the logic. "So that if you did not get through CA you could atleast get through ICWA." The professor was stumped but admitted that even he couldn't have explained diversification better.

Not every risk is diversifiable, Wafers had told herself. Getting married is a risk. But you cannot diversify by marrying more! She didn't raise that point in the class. She also told herself that while the CA-CWA was a cute example, it didn't quantify the extent of risk reduction. She turned to the brainy IIT-MMC duo of China and Muscles for help. And they didn't disappoint her. They told her a story.

Muscles' distant cousin lived in a god- forsaken place that had only one season, summer or winter, throughout the year. The cousin wanted to set up either a coffee pub or a soft drink joint. China suggested that he do a market survey before taking the plunge. Wafers remembered her professor's remark, "Its not enough to have a good idea; there must be a market for the good idea". A week later the cousin had come back. Market survey had suggested that if it were summer, the return from soft drink would be 40% while that from coffee would be 10%. If it were winter, the return from soft drink would be 10% while that from coffee would be 40%. "How would you know whether it would be summer or winter", Wafers asked China. "I wouldn't" said China. Her professor had said, "there are only probabilities, not certainties in life."

Muscles continued with the tale. "We asked my cousin to log on to the met department's website for statistics relating to the last 100 years." He had come back with the answer. "50 years summer and 50 years winter. So the probability was 50:50" Back of the envelope calculations indicated that the expected return from soft drink was 25%. [(0.5 X 40) + (0.5 X 10)]. Ditto for coffee pub business. The soft drink business carried risk because the return could be either 40% or 10% while the mean was 25%. Since this was true for coffee business too, the risk was identical.

"So what did you do?" asked Rinku. "Did you toss a coin and decide?" China said, "We asked Muscles' cousin to put half his money in soft drink and half in coffee pub". Muscles added, "Our logic was simple. In summer my cousin would get 40% from coffee and 10% from soft drink. Since he had put 50% of his money in either business his summer return would be 25%. [0.5 X 40+ 0.5 X 10] Ditto would be the winter return. And since the probabilities of summer and winter were 50:50 the overall return would be 25%. [0.5 X 25 + 0.5 X 25]." Wafers understood. Whether summer or winter the expected return would be 25%. Diversification had eliminated risk.
A mix of coffee and coke had helped her understand more about risk. How would such a cocktail taste she wondered?

Shall we play it straight

2008-08-24T22:11:00.000-07:00

Wafers believed that her parents had given her the best of education. They had sent her to the best of schools; later the best of colleges and now the best of accounting firms. She loved her parents; not that she ever told them that. Her dad: he held a top position, was instinctively honest and humble to a fault. The other day while she was on a train she met a stranger. In the course of conversation she learnt that he had worked with her father. "Oh you are his daughter? A brilliant man: simple, straightforward and honest". She couldn't help her eyes moisten. Would someone one day talk of her in those terms she thought.

Many summers ago when she was a tiny tot she would fight with Debbie for the top rank in her class. One day she had the opportunity to peek into the next test's question paper. That night her dad told her the story of an incredible Englishman who let pass the opportunity to win Wimbledon. At match point, in the semifinals, the Englishman served what the umpire thought was an ace. "Game, Set and Match to Roger Taylor." As an excited English crowd stood up to applaud Taylor, Taylor walked up to the umpire and said that his serve was out. The point was replayed. 15 minutes later his opponent walked out of Center Court beaming: he had won in 5 sets.

At the press conference a journalist asked Taylor, "Hey, how could you have been so stupid? Why did you overrule the umpire?" And Taylor remarked. "If I had done what you are now suggesting, then for the rest of my life whenever I see the Wimbledon trophy adorn the drawing space in my house I would be reminded not of my victory but of my innate dishonesty". It was a story that had made a deep impression in Wafers mind. In later years when she chatted this up with Rinku, her journalist friend, he wasn't impressed. He simply felt that Taylor was a sissy.

As Wafers grew up she learnt a few more things. She had always wondered, "If those who do wrong things don't get caught, then why have the law?" In moments such as these the story that her cousin narrated used to come to her mind. It was the 1986 World Cup soccer final. The reigning God, Diego Maradona, punched (yes punched) the ball into the net to give Argentina the goal and the World cup. Nobody protested. No one brought the house down. After all Diego was an icon. When quizzed about it Diego had said, "No it wasn't a hand ball. It was the hand of god." And mark it that phrase was what made media headlines. "Look", remarked Rinku, "the world always admires a winner. In life winning is not just the right thing. It is the only thing."

When she was young, Wafers' mother, a soft-spoken extra ordinary lady who personified humility, told her the story of Ben Johnson. The athlete had run the 100 meters dash at the 1988 Olympics in record time, 9 odd seconds, and had dedicated the victory to his mom. A few hours later, the world learnt that the Afro-American had tested positive for anabolic steroid (a banned substance) and he was banned for life. He had shamed himself, his mom, his countrymen and the spirit of the game as well. The press pilloried him. "From hero to zero in 9 seconds" is what they called him. When she told this to Rinku he was at his adamant best. "Johnson was stupid to get caught. By doing so he proved he was a loser. The world loves a winner."

Often during audits Wafers wondered as to what was it that mattered. Was it the letter of the law? Or was it the spirit of the law? In moments of such self-doubt this story invariably crossed her mind. She was in her diapers when it happened. It was the 1987 Reliance World Cup. Pakistan was chasing a West Indian target and the last pair was in the middle. Abdul Qadir, the burly Pakistani was at the non-striker's end and would constantly go for a run even before the ball was delivered. Unfair. On one occasion he was so stranded out of the crease that the bowler Courtney Walsh could have easily run him out. ("Mankaded him" is the cricketing phrase). Walsh didn't. He stopped near the stumps, didn't rip off the bails and simply waited for Qadir to come back! West Indies went on to lose the match and with it the chance of bagging the World Cup.

As Wafers' dad pointed out, "People have since forgotten who won that cup and by what margin but everyone remembers what Walsh did". He would have been within the letter of the law in running Qadir out. But he knew that the spirit mattered. Whenever Wafers reminded Rinku of this story the journalist pooh-poohed her saying Walsh, like Taylor, was a goody-good type. "They make good copy but they aren't the stuff winners are made of".

Today as Wafers sees a rash of Australian cricketers "walk" even when the umpire has ruled them not out, it doesn't create a lump in her throat. She realizes that they aren't doing anything extraordinary. They are just doing the right thing. And in the process setting an example for the youth to emulate. If we all play the game fair, the world would be a better place to live. Rinku wasn't willing to agree. Okay, he knew that the Aussies weren't sissies. But he felt that they were playing a mind game of a different kind! In a different context Wafers' professor had remarked, "Honesty may be the best policy but he who follows that policy is not necessarily honest."

"Roger Taylor. Courtney Walsh. Diego Maradona. Ben Johnson. Whom would you like to take home and introduce to your people as your friend?" Wafers asked. Who creates positive energy and who creates the negative? Rinku conceded, "Okay, this might be fine in a game; it cannot be fine in business." Chuin, Wafers' eight-year old kid brother, overhearing the last few words namely "game", "not business" chipped in "hey, a sport is also business. They make so much money." Wisdom from the mouth of babes? May be Wafers' professor was right. He had once said, "Companies that have traveled the distance from good to great have always walked the path of honor." How true.

Niceties of pricing services

2008-08-24T22:06:00.000-07:00

After her fairly instructive exchange with Doc (her senior audit manager) last week, Wafers had begun to appreciate how tricky service marketing was. And now there was this new dimension about service pricing. How does a lawyer figure out how much he should bill a client? Or a doctor decide what he should charge for a surgery. Her articleship gave her no lessons on these. She had turned to her cost accounting textbook for help. It offered no insights except to provide details of how transport companies, electricity boards and hotels price on the "cost plus margin" model. What about services that did not have any visible costs? She decided to fall back on the gang to get some clues.

It was China, her IIT pal, who provided the first insight. "Next time when you go to an optician's shop, watch what the optician does," he said. Rinku, the loud mouth reporter, was all ears. A story in as unglamorous a place as the optician's shop? Phew. "Opticians are trained to look at the customer's face when they quote" said China. "Suppose you are shown a range of glasses. You pick one and ask for the price. The optician would say "Rs 700". And if the expression on your face stays unchanged he would tell you, "Sir, that's only for the frame. The glasses will cost you extra." You ask him "How much?" and he tells you "Rs 300" again looking you straight in the face. If your face stays expressionless, he chips in "Sir that would be for one piece." Even Wafers smiled. "Who would want a frame and just a piece of glass?" She got the message. Pricing was based on "What the traffic can bear." Wasn't that the phrase her professor had used?

Wafers distinctly remembered that day. She had fallen sick and had visited a local doctor. He had asked her name and it pleased her. Good, she didn't have to be an anonymous patient. The doctor had then asked what her dad did. "Sr. Vice President, Citibank" she had told with pride. And mom? "Marketing Manager, HLL." Then came the clincher, "What are you doing Wafers?" "Me, doc? I am studying to become a chartered accountant." A few polite questions later came the doctor's consulting fee. Rs 300. She had flinched but had paid up. Later she narrated the incident to her professor and he smilingly told her "next time when you visit a doctor tell him your dad works in a private firm, your mom is a housewife and you are one of those unemployed millions and he will bill you Rs 25." She understood. "What the traffic can bear," closed out her professor.

Even as she was doing this trip down memory lane, Rinku, the reporter, was pontificating. "I cannot understand why if a demand draft for Rs 1000 could cost Rs 10, a demand draft for Rs 100,000 should cost Rs 2000?" Wafers agreed. "They don't need Rs 1990 to add two zeroes on the draft". The bearer, bringing in another plate of French fries chipped in. "There is no extra effort by the bank for the Rs 100,000 draft. See, they don't even have to count the cash!" Neither was there a risk. "Should the bank go belly up, it is the customer's money that goes down the tube," remarked Rinku. Wafers had the solution, "What the traffic can bear."

But is it that way always? The other day she had read that the maverick painter M F Hussein, a self confessed admirer of Madhuri Dikshit, had received a contract to paint 100 paintings each at Rs 1 crore. 100 crores, wow. She didn't even know how many zeroes would that have! Why should a Hussein painting fetch a million dollars? Do the tools and the material cost such a fortune? "Is there value for that money?" she mulled. In a different context, her professor had talked of how an Arrow Shirt costs thrice what a usual shirt made of similar material costs. Brand value. The customer gets a feeling of prestige paying that price! "Little wonder", he had remarked, "some wear shirts with the designers label stuck not inside, but outside the shirt for everyone to see"!

An excited Rinku offered another dimension to service pricing. He recalled an incident at the Press. The imported machinery had gone kaput and the service engineer was called in to set it right. The engineer opened up the equipment, spent 10 minutes looking at the 100s of parts that the machine had; removed two, rectified one, replaced the other and presto the machine was working again. The bill: Rs 500 for parts and Rs 2500 for service. An aghast official of the newspaper had scorned. "10 minutes work and Rs 2500? That's Rs 15,000 per hour or Rs 120,000 per day. Even my editor in chief doesn't earn that much". The service engineer responded, "Its not Rs 2500 for 10 minutes of work. Its Rs 2500 for figuring out which from out of the 100s of parts is working and which isn't and then setting it right". That settled it.

"What the traffic can bear." "Quality Price." "Brand Price." "Prestige pricing." "Vanity pricing." "Knowledge pricing." Wafers was beginning to learn a few things. And then China added his two bit "The price shouldn't be too high as to appear crass. Nor should it so low that people would doubt the quality of service". Rinku offered a supplement, "Would you trust a doctor who charged Rs 5,000 for a heart surgery?" Wafers remembered what her professor had once told the class, "If you offer peanuts you will get only monkeys." She was feeling happy. The gang had with its small talk had given her some insight into pricing. Bravo.

What if auditors advertised? What if they are sacked?

2008-07-03T06:06:00.000-07:00

For Wafers it was a very educative day at office. The nuggets that she picked up were devastating. Was this a case of her slowly getting transformed from being an airy-fairy student to becoming a worldly-wise adult?
It all began with Doc (that was how they called their Audit manager because he always swore by documentation) asking her to design a power point presentation. She loved power points and her presentations always wowed the people at office. Doc wanted her to draw up a profile of her audit firm. “What?” she exclaimed, almost falling out of her chair. An audit firm drawing up its profile reminded her of wannabe actresses, clutching their portfolio of photographs, walking up and down the office of producers. “Don’t you know” asked Doc, “there is a huge advertisement in the Economic Times from a multinational company asking audit firms to present their credentials for undertaking an audit”?

Wafers saw red. “But we can’t respond to that. The code doesn’t allow us,” she said, taking cudgels with her senior for the first time in two years. Clause 6 of the Code of Conduct which read, “A chartered accountant will be guilty of professional misconduct if he solicits client or professional work either directly or indirectly, by circular, advertisement, personal communication or interview or by any other means”, came blinking on her radar. “That’s okay,” said Doc almost reading her mind. “The ad has appeared on the Institute’s notice board which means it is par on course for us to apply! Also our firm has received a mail from the company asking us whether we would be interested?” “Barkins’ willing” remembered Wafers from Charles Dickens’ immortal book, “Great Expectations”.

The idea of a professional selling himself sounded jarring. She wondered what Muscles, her friend at the medical college, would say when he hears of this. “Would the world’s top neurosurgeons rush in their CVs if the head of a state wanted urgent medical attention?” she could imagine Muscles asking her. “Would you expect someone like C K Prahalad advertise his credentials for running a session?” she could imagine China chide her. Finally she brought herself to ask Doc, “Sir, should a professional at all respond to an ad?” Doc was curt. “Then how do they get to know of us?” he asked. His irritation was palpable. But Wafers couldn’t resist. “From here, the step towards direct soliciting will be small,” she insisted. Her worldly-wise manager said, “Madam, we are in the business of audit. Period.” So the line between profession and business had waned. She wondered how it would be if doctors, lawyers and teachers carried front-page advertisements. “Doing business without advertising is like winking in the dark; you know what you are doing, the other person does not” Doc added.

As she began to get over the initial shock more surprises were in store for her. The partner (they called him Boss) had listed out what should go into the presentation. First, he wanted a list of the firm’s top clients and the annual billing. “Would Dr. Denton Cooley, the world’s top heart surgeon, give a prospective client the list of his patients and how much he charged them”, Wafers asked herself. Next Boss wanted the head of audit and the composition of the audit team to be named. She could fancy Muscles saying, “So Cooley would have to name his operating team. He would have to say who would pick the scalpel, who would stitch the heart, who would cotton out the blood?” The next slide was to list the firm’s strengths and weaknesses. Wafers wondered what would come there? “Multi faceted work force” as a strength? A strong weakness for “poaching more clients?” She asked no one in particular, “Which audit firm would boldly say that albeit their audit, frauds of the most routine type might happen in a company? (E & O E).” It was getting confusing.

As she began adding a dash of color to a slide which talked about the average age of the firm’s relationship with each major client, she remembered something that her friend had confided in her. Of how his firm had lost a stat audit because it had stood by a view which the client didn’t favor. She had then wondered, “Would a fixed tenure followed by rotation of auditors be a good option”? Companies wouldn’t then be able to sack auditors at the drop of a hat. Auditors too wouldn’t bother too much about being on the right side of the client. “A firm gets to know a client may be after 3 years of work. Rotation would be professionally suicidal” her senior had remarked. Another disturbing (to her) point of view had been presented, “it takes us time to build a client relationship: how can someone unilaterally demand rotation.”

Her professor had remarked, “You cannot force a customer to choose his supplier.” Natty point, she had then conceded. Now she wondered whether the relationship between the stat audit firm and client was one between the supplier and the customer. Or whether it was one between the jury and, for want of a better phrase, the accused? While, the accused can select his lawyer, can he select his jury as well she wondered. Her professor had once told the class, “Between them the CEO and the CAO (Chief audit officer) can rob the company.” His choice of phrase may have been bad but she knew he had a point. “Caesar’s wife should be above suspicion” he had remarked in a different context.

But life at the ground level was different. Once when an audit firm had toed the client’s line drawing far fetched arguments to substantiate its point Doc had told her, “Look the audit firms have to make their living.” These (Marketing for clients. Retention of clients) are existential dilemmas which need to be tackled and cannot be pushed under the carpet. May be Doc was right. This is no longer a profession. This is becoming business. Like selling soaps and detergents. Like selling contact lenses. She didn’t cherish it one bit. Was she being old fashioned, she wondered? She knew that she had to talk to her professor. She instinctively trusted him in moments of crisis.

Watch cricket and learn decision-making

2008-07-03T06:05:00.000-07:00

“Could life be more unfair?” Wafers asked her dad. Classes at 0615 hours; fight for a place to sit; and 2.5 hours of heavy humorless learning. Phew. Then, rush for breakfast; zip through the crazy traffic to reach the client’s office to spend long hours amongst numbers and documents. Tiring. Spot an error like she did last week at Titanic (the multi million dollar company which she audited) that would lead to a huge dip in its bottom line and pronto the company would change its method of inventory valuation to make good the fall! “Could life be more unfair?” Wafers asked her dad again. He was on the couch, munching popcorn and watching the India-Pakistan test match on television. To him she simply did not exist there.

India, chasing an imposing 470 to win had just lost batting maestro Sachin Tendulkar and was tottering at 290/5 with two sessions to go. Who would come in next? The very very special Laxman or the dapper Yuvraj Singh? Mom who loved the lanky Hyderabadi wanted him to wield the willow. Dad, the homegrown Harsh Bhogle, swore it would be Laxman. Wafers who had trouble distinguishing a cricket bat from a baseball stick was jumping up and down “Yuvi, Yuvi, Yuvi.” “Will you shut up?” screamed Chuin (he crazy about chewing gum), her eight-year-old kid brother, ignoring protocol. “Why, why?” asked Wafers. “Laxman can score more runs than Yuvraj,” rammed Chuin. “Big deal”, remarked Wafers. “In the last ODI, chasing 270 and placed at 170 for 5 with 15 overs to go, it was Yuvraj who had come ahead of Laxman.” And condescendingly added, “You should know your history before passing judgment Chuin.” For a moment Chuin simply stared at Wafers. And then said, “Madam, this is a test match. Here the one who can score more runs is preferred. That was an ODI. There the one who can score faster is preferred”. For Wafers this was suddenly sounding familiar. But she couldn’t place it precisely. “Why the difference,” she haltingly asked. “Because in an ODI, the overs are limited. Hence “runs per over” is crucial” the little one said wondering whether his sister had only limited intelligence.

“My God. That’s it,” she screamed. “When there are no limiting factors the decision is based on contribution”, her professor had said while explaining Rule 5 in decision-making. “And when there are limiting factors the decision is based on contribution per unit of limiting factor” he had remarked laying out Rule 6. At that time she had wondered, “Why?” Now she knew. When overs are in plenty the decision is based on “Runs” (read contribution). When overs are in short supply the decision is based on “runs per over.” (Read contribution per unit of limiting factor.) You needed to get the maximum bang from the limiting factor. Her kid brother had cracked for her the marginal costing riddle. She looked at him in newfound admiration. He continued to watch the match unmindful.

The commercials came on the screen. She switched channels and found another version of cricket, the five-a-side tournament. Each team had a maximum of 20 overs to play and each batsman could bat a maximum of six overs. “How would the captain allot the overs?” Would he use Assignment or would it be Transportation she wondered! She turned to Chuin for help. Carefully she phrased the question. “Chuin, if you were the captain how would you rotate the batsmen?” she asked. “Six chocolates” said the kid indicating that this would be the price for the answer. “Even otherwise I would give you chocolates dear,” said his sister, half irritated. “Well, the best batsman will bat first,” said Chuin, fancying himself as Harsh Bhogle. From that Wafers extrapolated. She would have to rank the batsmen based on their strike rate. The best batsman would first play his six overs; the second best would next bat out his six overs and so on until the total number of 20 overs is exhausted.

“My god” she exclaimed. Wasn’t this sounding like the decision-making rule when the maximum number of units to be produced of a product is specified? “First, rank the products in the order of contribution per unit of key factor. Then, allot the maximum possible units to the best product, later to the second best product etc until the key factor is exhausted”. Eureka. That was Rule 7 of Marginal costing, the maximum rule as the professor had called, she realized with great joy. “What rule” asked Chuin? Wafers didn’t realize that she had actually screamed out the Rule. She ignored him. This cricket was helping her understand a few things about marginal costing and she wouldn’t allow some eight-year old to bully her, even if he was her brother.

Her mind began racing. What if the rules of the game were changed? What if each of the five players was to play a minimum of three overs. She simply had to apply a modified version of Chuin’s logic. She would have to find the best players based on strike rate. She would then allot the minimum three overs to each of the five players, eating up 15 in the process. The balance would go to the best player. So the best player would handle eight overs; the other four would handle three apiece. Wow. Rule 8 had fallen in place. Her professor had called it the minimum rule and had explained it step wise. “Step 1; rank the products in the order of contribution per unit of key factor. Step 2; allot minimum quantity to all the products and balance possible quantity to the best product”. Oh, if only he had offered this cute cricketing parallel it would have been great she told herself.
Thrilled at the increasing link between marginal costing and cricket she wondered what if the rules were changed further. What if each player was to play atleast 3 overs and at most 6? Well, she would first have to rank the players based on “runs per over.” Then she would have to allot the minimum three overs to each of the five players, eating up 15 in the process. The balance overs would go in sequence to the best player, the second best player etc until the overs were exhausted. Wow. Wasn’t that Rule 9? Wasn’t that what her professor had called the mini-max rule? He had of course explained it stepwise using business lingo rather than cricketing language. Decision-making was now like 1-2-3 for her.
Chuin was certain that his sister had gone bonkers. She was talking about runs, contribution, overs and products all in the same breath.

Who is the moral man?

2008-07-03T06:04:00.000-07:00

Wafers didn’t know how to react. The last few days were devastating. She was on an audit and scented a racket. Executives at Titanic (the company where she audited) traveled extensively during the year. The taxi fare from their residence to the station and from the station to the hotel was Rs 250/- apiece. They all claimed this as a matter of course. No documentary evidences were attached. What if they traveled by bus and pocketed the differential, she had asked herself. Her audit professor had told the class, “Auditors are watchdogs and not bloodhounds”. But that did not deter her.

When she looked into the tour reports and tour plans she noticed that the executives generally traveled in groups of five. Their work demanded so. She reasoned that from the station to the hotel and from the hotel to the station they wouldn’t be hiring five cabs, but only one. If true, it meant that they would really be spending only Rs 500 but between them would be claiming Rs 2500/- pocketing the Rs 2000/-. Wafers’ audit firm had drilled into her the virtue of sampling and extrapolating. She conducted 50 verifications and found that in 40 of them this was the practice. 80% of the sample committed this fudge. They had all charged the company Rs 500 each. She extrapolated the numbers. 1000 employees traveled during the year in groups of 5; this meant that 200 groups traveled. Such travels were 5 times a month. The excessive payment she reckoned was 200 groups X 5 times X 12 months X Rs 2000 = 240,00,000. Since 80% of the sample committed the fudge, the excess payment could be of the order of Rs 192 lakhs or close to Rs 2 crore she reasoned.

She had spoken to one of the Finance officers at Titanic and he was pretty evasive saying under the rules of the company proof of expending was not required. Her suspicion further strengthened, she spoke to one of the executives who regularly traveled and he took it cool saying this was par on course since he was drawing only what he was entitled to. She countered, “By that measure is it okay if one of your bosses travels by overnight train and claims air fare merely because he is eligible for it”. He simply smiled suggesting that Wafers was clearly wet behind the ears. Wafers ran through more documents and was shocked to find that senior executives at Titanic had checked into their hotels at 0600 hours, attended meetings at 0900 hours but claimed airfare for flights that would have actually arrived only at 1400 hours! Boarding passes and flight tickets weren’t required to be enclosed. A declaration would suffice. As Wafers ran up the audit on this she found that the company was out of pocket by another Rs 2 crore thanks to this practice. And in quite a few cases the boss’s wife traveled; “business promotion expenses” read the accounting entry. “The funeral expenses” of a senior manager was a business expense; “packing and forwarding” read the accounting entry. Aghast by all this she spoke up with her principal. He said he would talk with the management but his body language told her a different story.

Rather glum she narrated this story to the gang. Muscles winked, “So your auditor chose to look the other way?” He couldn’t forget the gossip at the medical college. And sounded out to the gang of how the brilliant professor who teaches them nephrology travels round the world thanks to pharmaceutical companies sponsoring expensive all paid trips for him and other top-notch doctors. A surprised Wafers asked, “do you think there is something hanky panky”. “No”, said Muscles, “The professor has a lily white reputation.” Rinku, the young reporter asked, “buy why should he accept these. Surely the pharmaceutical company would be expecting a quid pro quo of some kind.” And imagine doctors receiving referral fees when they send patients to the laboratories for tests, added Wafers. “No one is suggesting that there is an incestuous relationship in this but shouldn’t Caesar’s wife be above suspicion?” asked Muscles aloud. “You folks have a wrong sense of morality,” remarked China. “Titanic had the money to spend. In any case they were willing to spend. What the hell whether the employees spent it and collected or didn’t spend it and collected?” And then added, “the pharmaceutical company has to advertise its products. What the hell if this was the way to advertise to a doctor?” Its wrong if it acts as an inducement to taking a decision, it isn’t wrong if it’s a gift; a recognition of a good that you have done. “What should be the distance between a doctor and the detail person? The difference between the judge and the convict, the umpire and the player, the customer and vendor?” Rinku asked aloud, sounding a shade uppity about doctors and corporate executives.

That, in a sense, got into China’s goat. “Has the press been a shining paragon of virtue” he fumed. And slammed, “On the one side the papers attack the government and on the other side they make a song and dance if the government withdraws advertisements with the paper.” Wafers joined the match. “They carry huge advertisements of say Reliance and their analyst does a story on Reliance Mutual.” Muscles added for effect, “The food reviewer tastes the food on the house and then waxes eloquent on how it tastes.” The normally vociferous Rinku put up a feeble defense, “how do you expect newspapers to sell for Rs 2 when even a cup of tea costs more? Advertisements are the only way out.”

Wafers remembered her professor comment, “You scratch my back, I will scratch yours” as the philosophy that drove businesses. And had ventured to advise, “young ones when you step into the world tomorrow as fresh chartered accountants, if you want to leave footprints on the sands of time (his favorite turn of phrase she had noted) you have to stand for what is right even when the rest of the world is up against you. Well, well what about the corporate executives, the doctors, the auditors and the journalists she asked aloud. She must talk to her professor.

Coke, Pepsi and Pesticide

2008-07-03T06:01:00.000-07:00

For a change China wasn’t sipping coffee, Muscles wasn’t gobbling pizza and Wafers wasn’t having her mandatory bite of French fries. Instead, the gang was hot on soft drinks; one sipping Coke, the second sipping Pepsi and the third tasting some version of colored water – none knowing the difference. Wafers tired after a long day at audit, mixed up China’s coke, Rinku’s Pepsi and added salt to the cocktail. “What the hell; this isn’t good for health” fumed the medical intern with the hungry look, Muscles. He had always abhorred soft drink ever since his chemistry professor had told them about aerated water and gastric trouble. “Hey, hold on”, screamed China, his IIT mind racing like mad.
“How would it be if Coke and Pepsi merged first at the national level in India and later globally as well?” he asked. “Wow!” said Rinku, his journalist brain sensing a scoop where none existed. “Their ad budgets would come down by half,” he pointed out. Muscles, crazy about cricket, said “half the cricketers would go out of business.” China added, “With the two big boys marrying the marketing department can be slashed by 75%.” For Wafers the coin clicked. “Gain from synergy, ie 2 plus 2 adding to more than 4, is what drives M&A” the professor’s colorful slide had shown while she was staring out of the window watching the drizzle. How true. “But there would be no competition because between them Coke and Pepsi would have taken over the entire market” demurred Rinku, his mind for once working. “And that isn’t a good thing for society” remarked Wafers, recalling the article that she had read in HBR on the pros and cons of monopoly and competition. “But overwhelming volumes will bring about economies of scale and could actually drive prices southwards” said China. Wafers wasn’t convinced. With no competition there could only be more pesticides and more prices, she scorned. “Look at the magic that Air Deccan has caused in the airline industry” said Muscles. Without competition would prices have come hurtling down? Without competition would service have gone up? Would airhostesses of Indian Airlines smiled? Fat chance.

“Auditor”, screamed Rinku, “how would the numbers stack up?” He was hungry for a headline. “Suppose they save annually Rs 1000 crores because of the merger (nobody knew how she landed up with the figure), suppose this figure would rise annually by 5% (“inflation rate”, she patted herself on her back, for remembering that) and suppose the time value of money is 15% the value of the merger would be Rs 10,000 crore”. As Rinku looked at her with awe and she glowed in the halo, China winked, “That’s the present value of a growing perpetuity”. Wafers was stumped. This IIT fellow seems to know everything she told herself. Rinku asked, “Rs 10,000 is only a ballpark figure, isn’t it? It could be even Rs 100,000 crore if the annual savings was Rs 10,000 crore”? “Yup” said China and added “1 lakh crore would be almost 10% of India’s GDP”. Rinku got his headline “Pepsi merges with Coke to create India.” Wow.

Why aren’t they then merging wondered the reporter. As if reading his mind China said, “because there is no guarantee that it would click.” Remember, all these years the two companies had referred to each other as “We” and “They”. How could the duo now get to work together? Working together requires an abundance mentality and beyond a point people tend to lose that. For Wafers the coin clicked. Her professor had explained the antagonism between Coke and Pepsi that he had picked in the course of a consulting assignment. If a Coke employee is found sipping Pepsi anywhere in the world he is sacked pronto. The hate was mutual. If a Pepsi employee is found sipping Coke, anywhere in the world, he is sacked forthwith, the professor had said. Under such “mutual hostility, bruised sentiments and wild ego trips” there would be no meeting of minds. “What if one of them walked the extra mile?” asked Rinku. “Well both will have to do more than that,” remarked China. “If some bigness is good, an over abundance of bigness is not necessarily better” said Muscles, paraphrasing a lesson that had been taught in Anatomy. Wafers remembered how the mother of all mergers, Time Warner with AOL, had ended up with the merged entity reporting the largest loss ever in the history of financial reporting! “Some things just don’t work,” mused Rinku. But if it has worked in politics, which makes for strange bedfellows, why not in business asked China. “Because,” remarked Muscles, “while politics may be business, business is not politics”.

Wafers’s mind wavered. Of course there were other issues she thought. What if the merger actually worked? Well, the government would have to step in and stop it. After all, a private monopoly is as bad as a public monopoly. Remember how Microsoft had consistently killed the competition and invited the Anti Trusts Law? Muscles had a different take. “What the hell if there were no aerated drinks at all? Would there be a heart attack?” he asked aloud. Couldn’t both of them be asked to pack off? May be he had a point or two thought Wafers. “Business is not about making profits. It is about leaving footprints on the sands of time” her professor had said. If you want to travel the distance from good to great you have to do more than just color the waters he had remarked in his inimitable style.

Decision Tree

2008-07-03T05:46:00.000-07:00

The Big Day With Big B
Dateline: May 15, 2005.
Venue: The KBC game show.
India’s finest quiz show is back on air. An entire country, glued to its drawing space, watches the Big B with his patented French beard mouthing “Sure?” “Confident?” “Lock kiya jai?”. China, the hot wannabe engineer from IIT, took the flight to play KBC with Bachchan. He had spoken to Wafers, the bright young one who wanted to be a CA, that he would use her as the “phone a friend” option if there were a question on finance. “Oh, all that would be necessary only if you get into the hot seat,” ragged Rinku, the cub reporter. “Don’t be boorish. You had better be ready to interview the next crorepathi,” remarked Muscles, the young intern from the medical college.
The Big B landed at the studios, shook hands with the participants and got cracking. “Fastest fingers first” said Bachchan, indicating that he who got the answer first would get to play the game with him. “Who was the Greek philosopher ……………………….” Before he could complete, China had punched in the answer “Diogenes.” Unaware of China’s skills the Big B, after a pregnant pause, said “who lived in a tub?” What fastest fingers first; China had beaten even Bachchan hollow! An auspicious start indeed thought China. Would he bag the one crore prize?
He need not have worried. In no time he had cracked ten questions and won Rs 3.2 lakh. He hadn’t as yet used his lifelines. Q 11: “Who directed the music for the movie Bombay?” They might as well have asked him his grandfather’s granddad’s grandfather’s name. “Audience poll”, called China. The audience voted in favor of A R Rehman and China went with them. Questions 12 and 13 were simple and China, the ace quizzer, had won Rs 25 lakhs. Then came Q 14. “What part of the human anatomy enlarges to ten times its normal measurement during periods of emotion or excitement?” asked the Big B smiling. Ha, China knew the answer. Hadn’t Muscles told him about how the biology professor had asked this very question in the classroom to the lady doctor who was so stunned that she stammered “I .…. I refuse to answer that question.” The professor had said “Debbie, your refusal to answer makes three things evident. First, you didn’t study last night’s assignment. Second, you have a dirty mind. And third”, concluded the professor, “I am afraid marriage is going to be a tremendous disappointment for you”. Thanks to Muscles, China knew the answer and he beamed “The pupil of the eye.” Wow! He was now on Rs 50 lakhs and had two lifelines still in hand. After the mandatory claps the Big B forked out the Rs 1 crore question: “Who were the second set of people to win the Nobel prize for their work on capital markets?” China thanked his stars that he had sounded out Wafers to be ready for a call from him. The Big B trotted out the four sets (a) Modigliani and Miller (b) Black and Scholes (c) Harry Markowitz and William Sharpe (d) Warren Buffet and Peter Lynch. China had read about Buffet and Lynch, the legendary fund managers who had made cartloads of money for the investors. No Nobel Prize winner could do that he reasoned and ruled the pair out. The remaining three pairs made no meaning to him. He called for 50:50. Markowitz and Sharpe went out of the frame. And he had to choose between (a) Modigliani and Miller and (b) Black and Scholes. China decided to use his final lifeline and the Big B called Wafers. Ouch. The lady didn’t have the answer. She had bunked that class on capital markets and hadn’t caught up. China’s heart sank and he asked her “Okay, what should I do?” Wafers remarked, “Name anyone of the two pairs.” “What?” exclaimed China. And then elaborated, “If I get the answer wrong I pick only Rs 3.2 lakhs. If I walk out I get Rs 50 lakhs. I would prefer to walk out.” Wafers screamed, “No, I have read about decision trees in my classes. And it tells me that you should answer”. China too had read about this silly thing called “the trees”. His horn-rimmed professor at the IIT had said, “the value at a decision box is the higher of the expected values of the various branches that emerge from the box”. Even as he had dozed, the professor had thundered Rule 2, “the value at a chance node is the aggregate of the expected values of the various branches that emerge from the chance node”. And then for effect the professor had added Rule 3; “there are probabilities only at chance nodes and not at decision nodes”. While these thoughts raced through China’s head, Wafers elaborated: “You have to make up your mind on whether to “Answer” or “Not to Answer”. That’s a decision. If you decide “Not to Answer” you pick Rs 50 lakhs for sure and hence the expected value is Rs 50 lakhs. If you decide to “Answer”, your answer may turn out to be right or wrong. That’s a chance. Since there are only two choices, it’s like tossing a coin. There is a 50% probability of getting your answer right and a 50% probability of getting it wrong. If you get it right you win Rs 100 lakhs. If you get it wrong you win Rs 3.2 lakhs. The expected value therefore is (0.5 X 100) + (0.5 X 3.2) = Rs 51.6 lakhs. Since the expected value of “Answer” (Rs 51.6 lakhs) is greater than the expected value of “Not to Answer” (Rs 50 lakhs), China you must answer the question”. China trusted Wafers analytical skills but he couldn’t bring himself to let go the opportunity to make Rs 50 lakhs even if there was an expected value of Rs 51.6 lakh that Wafers talked of. He shook hands with the Big B and walked out. The Big B understood. Wafers didn’t. She was upset. Was her decision tree analysis faulty, she asked herself tersely?

Dateline: August 15, 2005. Wafers read a quote, “Men worry more about losing than about winning.”

Worry after a credit card party

2008-07-03T04:09:00.001-07:00

The gang was hanging out at one of Chennai’s up-market coffee pubs. China (because he always compared India with China) was having his third peg of coffee. Muscles (because he always looked puny and ever hungry) was attacking his fourth plate of pizza. Wafers (because she loved wafers) was having her nth bite of French fries and was beginning to mumble whether it was such a fine thing for her to have joined CA. China was at IIT and would surely go abroad while Muscles was studying to become a heart surgeon. Grimly Wafers contrasted their professions. If China messed up a civil construction hundreds of lives could be lost; he had to be careful in his work. If Muscles got an operation right, he would be treated as god. But what about Wafers? If she wronged up a transaction she could set it right with a rectification journal entry. How dull her profession was she wondered. No glamour, no chutzpah.She was broken out of her thoughts by a rattling noise. “Folks, its my treat”, screamed Rinku. Muscles couldn’t believe his ears. Rinku? And throwing a party? You might as well see the sun set in the East. China was sure Rinku was ragging them. “Which reporter would host a treat?” he wondered aloud. “They of the tribe who are used to free lunches”, muttered Wafers. “Did you bag the Bookers?” asked Muscles. Rinku wasn’t going to allow them to spoil his mood. “No I bought a credit card. Free.” Wafers’ eyes showed up. This was familiar terrain, finance. “But they don’t take credit cards in this pub”, remarked China. “No problem, I will draw cash from the nearby ATM” perked the scribe. “Sure?” asked China. “Confident?” asked Muscles. “Lock him,” screamed Wafers as they went in for another round of coffee, pizzas and French fries.Rinku ordered for pastas. “I received a call”, he said. The girl at the other end told me, “Sir, based on your track record of spending (Lie 1, when does Rinku spend thought Wafers) we have selected you for receiving a free card. With every Rs 100 that you spend you will get one reward point. And when you have accumulated 25,000 points (that’s Rs 25,00,000 spending computed Wafers) you will automatically qualify for a free return trip to Hollywood. What’s more you don’t have to pay for your purchases. Just send in a cheque (did Rinku have a bank account wondered Wafers) for 5% of the amount due and the balance can be carried forward at a small interest rate of 1.95% per month. If you run short of cash you can draw from the ATM and we charge only Rs 50/-. Sir, tomorrow our man will fill up the form for you, and help you sign it (Rinku’s thumb print would be better thought Wafers).” Of course the telephone girl had spoken nonstop the way only call center girls can. Rinku had supplied the punctuation marks!“Have you got your card,” asked Wafers, her mind furiously doing the calculations. “Of course. That’s why this treat. Actually, after one year, I can renew my card for a small fee of Rs 750 per annum” puffed Rinku, like a child with a new toy. Watching Wafers, Muscles knew she was about to chastise Rinku. Wafers was never wrong with her arithmetic. And you could read her face like a newspaper. There was no way that Muscles would allow her to spoil this lifetime opportunity of having a treat at Rinku’s expense. “Not now”, he snarled. And they ate. And ate, late into the night. Finally the ushers came to pull down the shutters. The bill arrived. Rs 960. Add a tenner as tip and Rinku could pay another Rs 30 to go home by auto. He would have spent the Rs 1000 that he had drawn from the ATM. Great night.As they walked down Wafers told Rinku, “it wasn’t such a smart thing drawing money from the ATM.” “Why?” asked China. “Because today is 16th Aug, the card statement will reach on 20th Aug and Rinku has to pay on 1st Sep. That means he has to pay Rs 1050 (transaction cost included) within 15 days. That’s an interest cost of Rs 50 on Rs 1000 for 15 days or 5% for 0.5 months. That’s 120% per annum. Period. Now which fool would pay 120% interest?” she asked aloud. “Rinkuuuuuuuuu, of course” said Muscles. Rinku wasn’t willing to let these folks give him a hangover. “Okay, I will use the revolving credit, pay only Rs 50 on 1st Sep and carry forward the balance Rs 1000 for payment on 1st October. That would mean I would have borrowed Rs 1000 for one and half months. Or 5% for 1.5 months. Or 40% per annum. And if I pay after 3 months the interest rate would come down further” mumbled Rinku, doing his math at a pace that would have got him the Olympic gold in the 100 meters dash. China muttered, “but boy you will be paying 1.95% per month as well. That’s 24% per annum.” Wafers was beginning to feel happy. “Look all these guys are quick in their arithmetic”, she told herself.Rinku slowly realized that he had been dealt with a bad hand. “Oh, God, why did I buy my card” he muttered. “Because, the telephone girl wanted you to buy one free” chipped in China. “Because you had to buy us coffee” said Wafers, adding insult to injury. Rinku threw up. “I will call up the girl and surrender my card”, he said. “Hey don’t do that” chirped Wafers. “Spend wisely; and using a card would be great. If you buy during the first week, you would enjoy about one month’s credit. Suppose you buy for Rs 10,000 a month. If you place that sum in a bank you earn Rs 750 (7.5% for 1 year on Rs 10000). So if you were buying for anything more than Rs 10,000 per month on your card, it would cover your membership fee. It would be a good card” beamed Wafers. Rinku was confused. Should he continue with the card or shouldn’t he? Muscles solved his dilemma reminding Rinku that he earned only Rs 7000 per month! Phew.

Accept or Reject

2008-07-03T04:04:00.000-07:00

Shall we go for the Movie?
It was another Friday night. The gang was at their usual joint, the Chennai coffee pub. China was having his third mug of coffee. Muscles was attacking his fourth plate of pizza. Wafers was having her nth bite of French fries and was as usual wondering whether it was such a fine thing to have joined CA. She had this morning been taught Decision Making and the good professor was simply beyond her. “Whether to accept a product or reject it?” This funny thing about contribution and that stupid thing about not distributing the fixed cost amongst various products simply beat her.

She was broken out of her thoughts by Rinku. “Lets go for a movie tomorrow”, he screamed. The stringer who always spoke in high decibel was wearing his trademark dirty jeans. “Does he sleep in his jeans” wondered Wafers. “What movie, where and how” asked Muscles eager to be away from hostel so that he need not read Gray’s book on Anatomy, for the test scheduled for Monday. China had no such problems. For him, the Monday’s test on “Strength of Materials” would be a cakewalk. Wafers had no issues at all. Her CA program never required her to take tests. The first examination would be the main examination. Phew.

“Where do we go?” asked Muscles. “Mayajal”, suggested China. Some 30 kms off the heart of Chennai city, on the East Coast Road, away from the monotony of ticking and verifying, would be fun, thought Wafers. “How much would a ticket cost?” asked the scribe. “Rs 100 per head”, said Muscles. “If four of us go it would be Rs 400/- and if five went it would be Rs 500”, added China for effect. For Wafers the coin clicked. Rs 100 per unit irrespective of the number of units. If the number of units is 4, the total variable cost would be Rs 400. If the number of units is 5, the total variable cost would be Rs 500. Wow! “The variable cost per unit is constant. The total variable cost varies with volume”, the good professor had told this morning. “That’s Rule 1”, hastily scribbled Wafers in her notebook. China got into the act. “At the Cineplex we will have to munch. Popcorn. Soft drinks. And then we must have dinner. It would cost us Rs 125 per head.” “If four of us go it would be Rs 500/- and if five of us go it would be Rs 625”, added Dr. Muscles. “Oh another variable cost” remarked Wafers, excited that Marginal costing wasn’t actually all that Greek. “Mayajal is so far away. How do we travel?” someone asked. “My car” said Rinku. Muscles couldn’t believe his ears. China muttered, “Hey we aren’t going for a press conference that someone would fund our trip”. Rinku ignored the jibe, picked up a scrap of paper and scribbled. 30 kms up and 30 kms down; total 60 kms. Fuel economy 10 Kms per litre. The trip would consume 6 litres. Petrol cost Rs 40 per litre. Rs 240 in all. Toll tax Rs 50 and car parking Rs 10. Total 300/-. He had it all stitched up.

“Rs 300 for us all”, said Muscles. If five of us go it would again be Rs 300. If only two of us went it would still be Rs 300. For Wafers the coin clicked a second time. Rs 300 irrespective of the number of units. In her notebook she hastily wrote in Rule 2, “Fixed costs remain constant irrespective of volume”. That’s what the good professor had told the class that morning. Rinku continued to scribble. Rs 100 per ticket, Rs 125 per head towards snacks and Rs 300 petrol and other fixed costs. For the four of them, it would be (100X4) + (125 X 4) + (300) = 1200. “Who will foot the bill?” asked Muscles. “Not me”, screamed Rinku. “Ask the auditor” said China. Wafers was smart. “We will go Dutch. Rs 1200/4 = Rs 300/- each”, she said. “Great”, agreed all.

Just then Neta (he had always wanted to become a politician) walked in. From Manishankar Aiyer to George W Bush, Neta had an opinion on them all. He wanted to join the “party”. Wafers, joyful in her new understanding of marginal costing did the arithmetic. Tickets; variable cost. Rs 100 per head. Snacks; variable cost. Rs 125 per head. Petrol etc; fixed cost. Rs 300 for all. Total (100X5) + (125 X 5) + (300) = 1425. No of people 5. Dutch cost Rs 1425/5 = 285 per head. From Rs 300 per head then, to Rs 285 per head now. There had been no reduction in cost; then how come the drop wondered Wafers. And she suddenly remembered. “As the number of units go up the fixed cost per unit comes down” the good professor had told this morning. Oh, “Rule 3” she told herself. This business of going for a movie was proving to be quite educative.

Neta zipped out his wallet to count. He had only Rs 250, not Rs 285/-. Wafers did her arithmetic again. Revenue (300 X 4) + Rs 250 = Rs 1450. Total cost Rs 1425. Net gain: Rs 25. Decision: Take Neta along. How come there was a gain when Neta brought in less than the average cost, Wafers wondered? The coin clicked a fourth time. Neta was bringing in Rs 250 as against the variable cost of Rs 225. That’s a contribution of Rs 25. The professor had remarked, “Products with positive contribution should be accepted.” Wafers scribbled that in as Rule 4. What if Neta brought less than Rs 200, she asked herself. Well, he would have to be dropped. The professor had said, “Products with negative contribution should be rejected.” Ha, Rule 5.

Then came the final click. In all her analysis on whether Neta should be in or out, the fixed cost of Rs 300 had been ignored. The decision had been based on contribution only. “Fixed costs which do not change are irrelevant to decision making” the professor had explained that morning. Enter Rule 6. How instructive. Quite a few rules had fallen in place. Marginal costing was no longer giving her sleepless nights. Wafers looked forward to going for the movie in the hope that the travel would help her unravel a few more rules of marginal costing.